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I ns t i t ut eo fMa na g e me nt & Te c hni c a lSt udi e s MANAGEMENTACCOUNTI NG

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IMTS (ISO 9001-2008 Internationally Certified) MANAGEMENT ACCOUNTING

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UNIT- I

01-07 Management

Accounting-Nature

And

Scope-

Meaning-

Definitions-

Objects

Of

Management Accounting And Financial Accounting –Management Accounting And Cost Accounting. UNIT-II

08-14 Analysis And interpretation Of Financial statements- The Concept Of Financial Statement-

Limitations Of Financial Statements-Analysis And Interpretation- Tools-comparative Financial Statements- Common Size Financial Statements And Trend Percentages. UNIT- III

15-41 Ratio Analysis-Nature, Interpretation and Limitations of ratios- Short-term and Long-term

financial ratios-Profitaility. Efficiency, proprietory and yielding ratios. UNIT-IV:

42-64 Fund Flow Analysis-Concept of funds-Sources and uses of funds-Concept of Fund Flow

Statement-Managerial uses of Fund Analysis-Construction of fund flow Statement- Distinction of Cash from funds- Utility of cash flow statement-Construction of cash flow statement. UNIT-V:

65-100

Marginal Costing And Break - Even Analysis For Profit Management and Control. Capital Budgeting Nature of Capital expenses - Concept Of Capital Budgeting- Capital Budgeting Procedures- Methods Of Ranking Investment Proposals- Simple Problems Involving Payback Method- Average Rate Method And Discounted Cash Flow Methods.

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UNIT – I MANAGEMENT ACCOUNTING OBJECTIVES: After reading this lesson the student should be able to Understanding the meaning of Management accounting Understanding the objectives of Management accounting Appreciate the importance of Management accounting in decision- making. Distinguish Management accounting from cost accounting and Financial accounting. Realize the limitations of Management accounting. STRUCTURE: 1. Introduction 2. Meaning and definitions of Management Accounting. 3. Objectives of Management Accounting 4. Functions of Management Accounting 5. Advantages of Management Accounting 6. Limitations of Management Accounting 7. Management Accounting Vs Financial Accounting 8. Management Accounting Vs Cost Accounting 9. Summary

1. INTRODUCTION:Management Accounting is a primarily concerned with providing information relating to the conduct of the various aspects of a business like cost or profit associated with some portions of business operations to the internal parties viz; management. This category of accounting is called as “Management Accounting”.

EVOLUTION OF MANAGEMENT ACCOUNTING:

The objective of accounting is not only to keep records and prepare final accounts but also to help management in its basic functions which are becoming day-by-day more complex and complicated. But it was found that the traditional accounting i.e financial accounting could not meet

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requirements of the management today due to many reasons. The first and foremost reason is that financial accounting provides information only about past records. It does not tell the management as to how the business has fared at each stage of operation. It also does not tell what should be the future policy of the management in order to achieve the targets set or to set new targets. Thus financial accounting cannot cope with the varies business problems. So to overcome the defects and limitations of financial accounting which is said to be static, management accounting which is a dynamic process has been evolved.

MEANING OF MANAGEMENT ACCOUNTING:-

The term Management accounting refers to accounting for the Management - Management accounting provides necessary information to assist the management in the creation of policy and in the day-to-day operations. It enables the management to discharge all its functions that is planning, organizing, staffing, direction and control. efficiently with the help of accounting information.

DEFINITIONS:-

“Management accounting is concerned with accounting information that is useful to management” --R.N.Anthony

As fer Anglo American council of productivity, “Management accounting is the presentations of accounting information in such a way as to assist management in the creation of policy and in the day-to-day operations of an undertaking”. According to John seizer Management accounting as “ The application of accounting techniques to the provisions of information designed to assist all levels of management in planning and controlling the activities of the firm”.

OBJECTIVES OF MANAGEMENT ACCOUNTING:-

The objectives of management accounting are :1. To assist the management in promoting efficiency. Efficiency includes best possible services to the customers, investors and employees. 2. To prepare budgets covering all functions of a business. i.e. production, sales, research and finance 3. To analysis monetary and non- monetary transactions. 4. To compare the actual performance with plan for identifying divisions’ and their causes. 5. To interpret financial statements to enable the management to formulate future policies.

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6. To submit to the management at frequent intervals operating statements and short-term financial statements. 7. To an analyse for the systematic allocation of responsibilities. In short, the objective of management accounting is to help the management in making decisions and implementing them efficiently.

FUNCTIONS OF MANAGEMENT ACCOUNTING:-

Function of Management accounting include all activities connected with collecting, processing, interpreting and presenting information to the management. The main function of Management accounting are:1. Fore casting:- Making short-term and long-term forecasts and planning the future operations of the business 2. Organizing:- organizing the human and physical resources of the business. This is done by assisting specific responsibilities’ to different people. 3. Co-ordination:- providing different tools of co-ordination. Examples of such tools are budgeting, financial reporting, financial analysis, interpretation etc. 4. Controlling:- controlling performance by using standard costing, various analysis and budgetary control. 5. Analysis and inter predation:- Analyzing and interpreting financial data in a simple and purposeful manner. 6. Communicating: Communicating the results of business activities through prompt and accurate reporting system. 7. Economic appraisal:- Appraising of social and economic forces and government policies and interpreting their effect on business. ADAVANTAGES OF MANAGEMANT ACCOUNTING

As management accounting has emerged to overcome the limitations of financial accounting, it is needless to point out that many advantages which are not associated with financial accounting are available with management accounting. The advantages of management accounting are summarized below:1. Helps in decision making:- Management accounting helps in decision- making such as pricing, make or buy, acceptance of additional orders, selection of suitable product mix etc. These important decisions are takenwith the help of marginal costing technique

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MANAGEMENT ACCOUNTING 2. Helps in planning:- planning includes profit planning, preparation of budgets, programmes of capital investments and financing. Management accounting assists in planning through budgery control, capital budgeting and cost- volume profit analysis. 3. Helps in organizing:- Management accounting uses various tools and techniques like budgeting, responsibility accounting and standard costing. A sound organisational structure is developed to facilitate the use of these techniques. 4. Facilitates communication:- Management accounting is provided with up-to-date information through periodical reports. These reports assist the management in the evaluation of performance and control. 5. Helps in co-ordination: The functional budgets ( purchase budget, sales budget, overhead budget etc ) are integrated into one, Known as master budget. This facilitates clear definition of departmental goals and co- ordination of their activities. 6. Evaluation and control of performance:Management accounting is a convenient tool for evaluation of performance-with the help of ratios and variance analysis, the efficiency of departments can be measured. Management accounting assists the management in the location of weak spots and in taking corrective actions. 7. Inter predation of financial information:Management accounting presents information in a simple and purpose full manner. This facilitates quick decision-making. 8. Economic appraisal:- Management accounting includes appraisal of social and economic forces and government policies. This appraisal helps the management in assessing their impact on the business. LIMITATIONS OF MANAGEMENT ACCOUNTING

No system in the universe is perfect. This applies to accounting system also.This applies to management accounting system also. The management accounting system suffers from certain limitations. These limitations are taken into account the so-called advantages cannot be reaped. The various limitations of management accounting are listed below:1. Based on accounting information :- Management accounting derives information from past financial accounting and cost accounting records. If the past records are not reliable, it will affect the effectiveness of management accounting. 2. Wide scope:- Management accounting has a very wide scope incorporating many disciplines. This results in inaccuracy and other practical difficulties.

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3. Costly:- The installation of management accounting system requires a large organization. Hence, it is very costly and only big concerns can afford to adopt it. 4. Evolutionary stage:- Management accounting is still in its initial stages. Tools and techniques are not fully developed. This creates doublts about the utility of management accounting 5. Opposition to change:- Introduction of management accounting

system requires a number of

change in the organization structure, rules and regulations. This rearrangement is not generally liked by the people involved. 6. Intuitive decisions:- Management accounting helps in scientific decisions making. Yet because of simplicity and personal factors the management has a tendency to arrive at decisions by intuition. 7. Not a alternative to management:- Management accounting will not replace the management and administration. It is a tool of the management.

Decisions are of the management and not of the

management accountant.

MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING

Financial accounting and Management accounting are two interrelated facts of the accounting system. They are not independent of each other. They are interdependent. They are Supplementary in nature. A distinction is always drawn between financial accounting and management accounting since they differ in their emphasis and approaches. Some of the points of differences between these two accounting systems are given below:-

1. Objectives:- The main objective of financial accounting is to supply information in the form of profit and loss account and Balance sheet to outside parties like share holders, creditors, government etc. But the objective of management accounting is to provide information for

internal use of

management.

2. Performance analysis:- Financial accounting is concerned with the overall performance of the business. On the other hand management accounting is concerned with the departments. It reports about the performance and profitability of each of them.

3. Data used: Financial accounting is mainly concerned with the recording of past events where as management accounting is concerned with future plans and policies.

4. Nature:- Financial accounting is based on measurement while management accounting is based on judgement. Because of this financial accounting is more objective and management accounting is more subjective.

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5. Accuracy:- Accuracy is an important factor in financial accounting. But approximations are widely used in management accounting. This is because most of the information is related to the future and interest for internal use.

6. Legal compulsion:- Financial accounting is compulsory for joint stock companies. But management accounting is only optional.

7. Monetary transactions:- Financial accounting records only those transactions which can be expressed in terms of money.

On the other hand, management accounting records not only

monetary transactions but also non-monetary events, namely technical changes, government polices etc.

8. Control:- Financial accounting will not reveal whether plans are properly implemented. Whereas management accounting will reveal the deviations of actual performance from plans. It will also indicate the causes for such deviations. MANAGAMANT ACCOUNTING Vs COST ACCOUNTING.

Costing has been defined as classifying recording and appropriate allocation of expenditure for the determination of the costs of products or services. Cost accounting will tell the management as to how the business has fared and each stage of operation. But cost accounting will not tell them anything about the future policy to be adopted. The following are the main differences between cost accounting and management accounting: 1. Objective:- The objective of cost accounting is the ascertainment and control of costs of products or services. But the objective of management accounting is to help the management in decision making, planning, control etc. This objective is achieved by furnishing relevant accounting information to the management. 2. Scope:- cost accounting deals primarily with cost data. But management accounting deals with both cost and revenue. It includes financial accounting, cost accounting, budgeting, reporting to management and interpretation of financial data. Thus the scope of management accounting is wider than that of cost accounting. 3. Data used:- In cost accounting, only those transactions which can be expressed in figures are taken. only quantative

aspect is recorded in cost accounting. But management accounting uses both

quantitative and qualitative information.

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Cost accounting uses both past and presend figures. But management accounting is

concerned with the projection of figures for future. The policies and plans are prepared for providing future guidelines.

However, cost accounting and management accounting are Complementary in nature. Cost accounting furnishes detailed cost information. Management accounting analysis and presence the data in a more meaningful and informative manner. It helps the management to use the cost data effectively. Summary:-

Accounting can no longer be considered as a mere language of business. Now a need has arisen for accounting to provide information, relating to the conduct of the aspects of a business like cost or profit associated with some portions of business operations to the internal parties viz. Management. Traditional accounting i.e financial accounting cannot provide this. Hence management accounting was evolved to fulfill this need. Thus the objectives of management accounting are to present the required facts and information for the use of management in a quantive form and to help in effective performance of managerial functions i.e. planning, organizing, controlling, and decisionmaking etcA concern will derive many advantages with the help of management accounting like systematic regularity in the business activities through efficient planning and effective organization, increase in efficiency of the concern by comparing actual performance with expected performance and suggesting remedial measures to avoid the recurrence of adverse variances, cost reduction and consequent price reduction by the application of various types of controls in accounting areas etc.

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UNIT-II FINANCIAL STATEMENT ANALYSIS After reading this lesson the student should be able to Understand the implications of financial statements as performance records of an enterpriseAppreciate the methods to carry out Financial statement analysis, Learn the procedure

to prepare comparative financial statements,

Trend percentages and common size statements Financial statements refers to a package of statements such as Balance sheet, income statement, fund flow statement, cash flow statement

and statement of retained earnings. The

balance sheet and income statement are traditional financial statement. Other statements are prepared to supplement them. Objectives:- The following are the main objectives of financial statements analysis:1. To establish the earning capacity of the concern. 2. To judge the financial (both liquidity and solvency) Position and financial performance of the concern. 3. To determine the debt capacity of the concern. 4. To decide about the future prospects of the concern. NATURE OF FINANCIAL STATEMENTS:According to the American Institute of certified public Accounts, �Financial statements reflect a combination of recorded facts, accounting principles and personal judgments�. The following points explain the nature of financial statements:1. Recorded facts:- The term recorded facts refers to the data taken out from accounting records. Facts which have not been recorded in the financial books are not depicted in financial statements however important they might be. For example. Fixed assets are shown at cost irrespective of their market or replacement price, since only cost price is recorded in the books. 2. Accounting principles:- Certain accounting principles concepts and conventions are followed in the preparation of financial statements. For example, the convention of valuing stock and cost or mark price whichever is less is followed. The principle of valuing assets at cost less depreciation is followed for balance sheet purpose. 3. Personal judgment:- personal judgment has as important bearing on the financial statements. For example, the selection of a method for stock valuation depends on the personal judgment of the accountant.

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MANAGEMENT ACCOUNTING LIMITATIONS OF FINANCIAL STATEMENTS Financial statements are relevant and useful for a concern. But they do not present a final picture. Financial statements suffer from the following limitations: 1. Financial statements are only interim reports. They are not final, because the exact financial position can be known only when the business is closed. 2. Many items in the financial statements are based on the personal judgment of the accountant. 3. In the balance sheet, assets are recorded at their original costs. Replacement cost or realisable value of the assets is ignored. Hence it does not reveal the true position of the business. 4. No monetary factors such as credit worthiness reputation of the management, influence the financial position of a concern. But the financial statements do not take in to account these factors. 5. Financial statements ignore the changes in price level. Hence their use is limited during inflationary periods. 6.

Financial statements are records of past events only. past can never be a hundred percent representative of the future.

7. Financial statements are prepared on the basis of certain accounting concepts and conventions. Any change in the method or procedure of accounting limits the utility of financial statements. 8.

The balance sheet fails to show how working capital was raised and used during the year. This is a serious limitation as changes in working capital are important to assess the financial health of a company. INTERPRETATION OF FINANCIAL STATEMENTS

Analysis and interpretation of financial statements is the most important step in accounting. To have a very clear understanding of the profitability and financial position of a company, the financial statements have to be analysis and interpreted. Analysis refers to the methodical classify cation of the data given in the financial statements. For example, the amount of capital employed is not directly available in the balance sheet. The figures have to be re-arranged to calculate the amount of capital employed. The term “ interpretation� means explain the meaning and significance of the data so arranged It is the study of the relationship between various financial factors. The relationship between profit and capital employed, current assets and current liabilities. sales and gross profit have to be explained. Further to make interpretation more meaningful, comparisons have to be made. comparison of relationship between various financial factors of the same company over a period of time can be made. For, Example, gross profit ratios of several years may be compared similarly comparisons can be made between two or more companies. This is popularly known as inter firm comparisons. Analysis and interpretation are closely related. Interpretation is not possible without analysis and without interpretation analysis has no value. Hence, the term analysis is widely used to refer

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both analysis and interpretation. In short, analysis and interpretation of financial statements require the following: 1. Methodical classification of the data given in the financial statements. 2. Explaining the meaning and significance of the relationship between various financial factors. 3.

Comparisons of these relationships. It is a process of evaluating the relationship between the various components of a financial statement to obtain a clear understanding of a firms position and performance.

METHOD OF FINANCIAL STATEMENTS ANALYSIS

It is now clear that the analysis of financial statements provide necessary insights towards establishing relationships and trends to determine whether or not the financial position and length of operations as will as financial progress of the company are satisfactory or not. some of the analytical methods used to analyses financial statements are: 1.

Comparative financial statements

2.

Common size financial statements

3.

Trend percentages

4.

Ratio analysis

5.

Fund flow analysis.

1.

Comparative statements:Financial statements are prepared as on a particular date or for a particular period. For

example, balance sheet indicates the financial position as at the end of the period and the income statement shows the operating results for a period (usually a year). But a financial analyst is interested in knowing whether the business is moving in a favorable or unfavorable direction. For this purpose, figures of the current year, have to be compared with those of the previous year. Compared financial statements provide information to assess the direction of change in the business. In these statements, figures for two or more periods are placed side by side to facilitate comparisons.

Any financial statement can be proponed in a comparative form. But in practice, balance sheet and income statement are alone prepared in a comparative form. Under the companies Act, 1956, companies are required to show figures for the previous year together with current year figures in their profit and loss account and balance sheet.

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Proforma of Balance sheet as on………………. particulars

Current year

Previous year

Figures(Rs)

Figures(Rs)

Cash at bank

xxx

xxx

Cash in hand

xxx

xxx

Bills receivable

xxx

xxx

Marketable

xxx

xxx

xxx

xxx

1.Liquid assets

securities Total(1)

II Inventories:Raw materials

xxx

xxx

Finished goods

xxx

xxx

Total(2)

xxx

xxx

III. Total current assets (1+2)=3

xxx

xxx

Bills payable

xxx

xxx

Creditors

xxx

xxx

Bank over draft

xxx

xxx

Out Sanding

xxx

xxx

Total(4)

xxx

xxx

Provision for taxation

xxx

xxx

Proposed Dividends

xxx

xxx

Other provisions

xxx

xxx

Total (5)

xxx

xxx

xxx

xxx

Iv current liabilities:

V. provisions:-

Vi Total current liabilities and Provisions (4+5)=6

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Vii Net working capital (6-3)=7

xxx

xxx

Land and buildings

xxx

xxx

Plant and machinery

xxx

xxx

Furniture and fixtures

xxx

xxx

Equipment and tools

xxx

xxx

Total (8)

xxx

xxx

Total capital employed (7+8)=9

xxx

xxx

xxx

xxx

Less Balance

xxx

xxx

Total

xxx

xxx

Debentures

xxx

xxx

LT loans

xxx

xxx

other secured loans

xxx

xxx

Viii Net Block.

Ix capital employed as represented by equity:Equity share capital:-l Reserves and profit and loss:a/c Balance

x capital employed as represented by bonds and debentures:-

Performa of profit and loss a/c as an‌

Particulars

current year figures Rs

Sales

previous year figures Rs.

xxx

xxx

xxx

xxx

_____

_____

_____

_____

Adm : overhead expenses

xxx

xxx

Distribution over head expenses

xxx

xxx

Selling overhead expenses

xxx

xxx

Financial overhead expenses

xxx

xxx

Less: cost of goods sold (cost of materials consumed + direct wages + other direct expenses)

Gross profit Less: overhead expenses:

______ ______

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Net profit

______ ______

COMPARATIVE BALANCE SHEET

The single balance sheet shows assets and liabilities as an a particular data. The comparative balance sheet shows the value of assets and liabilities on two diffident dates. If helps in comparison. A comparative balance sheet has two columns to record the figures of the current year and the previous year. A third column is used to show the increase or decrease in figures. A forth column may be added for giving percentage of increase or decrease. Thus, while in the balance sheet the emphasis is on status in the comparative balance sheet it is on change. Comparative balance sheet indicates whether the business is moving in a favorable or unfavorable direction it is very useful for studying the trends in an enterprise. Comparative income statement:An income statement shows the operating results of a business for a designated period of time.

A comparative income statement shows the operating results for a number of accounting

periods so as to facilitate comparison. It gives an idea of the progress of a business over a period of time. It gives an idea about the improvement in sales, profit and other expenses over the previous year. A comparative income statement has two columns for the figures of the current year and the previous year. A third column is used to show the increase or decrease in figures. A forth column may be added for giving percentage of increase or decrease.

2. COMMON SIZE STATEMENTS:Financial statements present absolute figures. A comparison of absolute figures could be misleading. For example, cost of sales in absolute figures might have gone up but as a percentage of sales it might have come down. Hence, for a better Understanding and comparison, the figures are converted into percentage of some common base. The statements which report the figures as a percentage of some common base are called common size statements. Sales is taken as the conmen base in the common size income statements. All expenses are recorded as a percentage of sales. In the common size balance sheet, total assets or liabilities is taken as the common base. Each item is expressed as a percentage of the total. Command size, Statements are useful to a financial analysist. They make comparison easy and meaningful. 2. TREND PERCENTAGES:Trend analysis is very helpful in making a comparative study of the financial statements of several years. Under this technique, information for a number of year is taken up and one year (usually the first year) is taken as the base year. Each item of the base year is taken as 100 and on

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that basis, the percentage for other years are calculated. For example, if sales in the base year is Rs.10,000 and in the next year it is 20,000, the trend percentages will be 100 and 200 respectively. Substitution of percentages for large amounts makes the statements brief and easily understand able.

In short, comparative statements, common size statements and trend analysis present the information contained in balance sheet and income statement in a form suitable for analysis. Such presentation helps in a better understanding of the financial statements. Summary: Financial statements convey a lot of information to both the external as well as internal users. Meaningful comparison can be drawn from a systematic analysis of the financial statements by carrying out the comparative analysis, constructing common size statements as well as Trend percentages. The construction of comparative statement explores the periodic changes in various items listed in both balance sheet as well as in profit and loss account . This periodic changes could be analysed either in absolute values or in terms of percentage changes The common size statements analysis tries to provide an in-death examination of each of the financial statements by developing inter relationship between various items with one ‘base’ figure. In case of income statement the annual ‘sales’ figure acts as the ‘base’ to find the proportionate changes in different costs and the profit margins annually. The Trend percentage method tries to explore into possible trends in the operating performance of the enterprise through the construction of trend percentages keeping one of the year’s performance as the ‘base’. Therefore this method examines more number of years of information compared to the earlier one. So, these analysed figures of financial statements are more meaning full for decision making.

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UNIT-III RATIO ANALYSIS Financial statements are statements of income and balance sheet which highlight the income or profitability and change in the fixed assets and capital during a specific period. It provide a summarized analysed view of the operations of a firm. These statements may be more fruitfully used if they are analysed and interpreted to have an insight into the strengths and weakness of the firm. The success of the company’s financial plans is based on the financial analysis which is the starting point for making plans, before using any sophisticated forecasting and budgeting procedures. Various tools are employed by the interested parties in analysing the financial information contained in these statements. Ratio analysis one of the important techniques to explain salient features of financial statements It is needed for evaluating the financial statements. Meaning The relationship between two figures expressed mathematically is called a ‘Ratio’ It is a numerical relationship between two numbers which are related in some manner. Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of determination and interpretation of various rations for helping in decision making. Ratio analysis involves thtee steeps: 1. Calculation of appropriate rations from the financial statements. 2. Comparision of the rations with standards or with rations of the past period-

comparision can also

be made with the ratios of other firms. 3. Interpretation of ratio. DEFINITION “Ratio is expression of the quantitative relationship between two numbers” -Wixon,Kell and Bedford, “Ratio as simple one number expressed in terms of another” -Robert Anthony

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SIGNIFICANCE/MERTS/IMPORTANCE OF RATIO ANALYSIS

1.

Test of solvency:The use of ratio is useful in testing the solvency position of the company. when percentage of

gross profit to sales is increasing, it shows the efficiency of profitability. Likewise, when ratio of current assets to current liabilities shows upward trend, it means sufficient working capital. Thus the claim of creditors can be paid easily. 2.

Helpful in decision making:The main object of financial statement is to tell the financial position of the company up on

which management takes decision. 3. Helpful in financial forecasting and planning:The ratios are utmost use in financial planning, forecasting and work as a future guide. The ratios are used for drawing conclusion such as current ratio is 5:1, it means blocking up of capital as the ideal ration is 2:1 whereas we have 5:1, Rs.3/- are unneessanily blocked. 4. Useful in knowing profitability:The ratios are most useful when comparison is made between companies for profitability. Two types of comparison of percent ratio with past ratio and the second comparison of several previous years are computed with the objective of knowing improvements or down falls in the financial position. 5. Liquidity position:With the use of ratio analysis the meaningful conclusion regarding the sound liquidity position of the firm. The liquidity position is sound if it has the ability to pay its debts when these are due for payments. 6.

Helpful in knowing operating efficiency:The ratios are important from the management point of view where in the management

measures the efficiency of the assets. The sale and its percentage to net profit is increasing every year is a test of increasing in efficiency. 7.

Business Trend:The ratio analysis speaks of the financial discipline of the firm with raged to additions and

down fall. When the trendsis for downfall the management can take corrective decisions. 8.

Helpful In Cost Control:Comparison of actual ratios with the standard reveals the deviations and weaknesses. This

helps the management to take corrective action at the right time.

Control of costs as well as

performance are ensured.

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Helpful in analysing the financial health of the company:The ratio are very useful in highlighting the liquidity, solvency, profitability and Capital gearing.

Thus, these are a useful tool of analysing financial performance.

INTERPRETATION OF RATIOS The importance of ratios, as a tool of analysis, lies in its proper interpretation by the financial analyst. There are four different method applied for interpretation of ratios. 1.

The individual ratio by itself may convey a significant meaning of the related items.

For

instance, if the current ratio consistently falls below one, it may reveal the impending financial solvency of the concern which only means that the current assets of the units are not even sufficient to meet current liabilities. circumstances and

It is very rare with regard to a business concern under normal

one cannot also jump to any hasty conclusion after studying the ratios in

isolation. Moreover a single ratio at times may fail to reveal the exact financial position. 2.

The interpretation of ratios can be effected by taking into analysis a group of related ratios in

sufficient number. By complication and analysis of group of inter related ratios, the significance of ratios can be fully understood when the same cannot be achieved in isolation. For instance, the value of net profit ratio is increased by taking the ratio disclosing the number of times the proprietor’s investment is turned over in sales every year. 3.

The interpretation of ratios involves comparison of ratios of one business concern with those of

others which is often referred to as “inter firm comparison”. This comparison provides the valuable information as in most cases, members of the same industry face similar problems – internal as well as external. These comparisons are often facilitated by the use of the tables summarising the ratios of units in a particular industry. These tables are usually prepared by trade associations and credit agencies. 4.

The interpretation of ratios involves making comparison of ratios of the unit over a period of

years. By this, the same ratio or a group of related ratios of a business concern is compiled and evaluated over a period of years. This study highlights significant trends showing the rise, fall or stability achieved by the unit. The average value of a particular ratio for a number of years can save as a standard against which the future performance can also be compared.

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18 LIMITATIONS OF RATIOS

No doubt ratios are useful tools yet these should be used with utmost care as these suffer from certain drawbacks, which are as: 1.

Need detailed knowledge:The calculation of ratio is not so much difficult as it interpretation. Ratios are tools of

quantitative analysis and not of qualitative analysis. Thus, one should have a fair knowledge of qualitative and quantitative analysis. 2.

Lack of raliable data:Ratio can give misleading results if the analyst does not know the reality and correctness of

figures. For example, the value of closing stock is over stated, profit will be inflated, this will result in more taxation when actual profits are less than the profits on which tax has been paid. 3.

Different Basis:There are different methods of valuation of closing stock (i) LIFO (ii) FIFO in both profit will

differ. Similarly profit has different meanings. Some one may say profit before tax and interest, while others may take profit after tax and Interest.

Similarly, different methods of depreciation, each

method will show different amount of profit. 4.

Different accounting policies:Different firms follow different policies withregard to depreciation, fixed instalments or

diminishing balance method or stock valuation. LIFO, FIFO, thus profit so calculated will not be comparable unless adjustment for profit is not made. 5.

Effects of price level change:While ratio are calculated, no thought is given to inflationary measures which is responsible for

change in price level. Thus the whole utility of ratio analysis becomes stand still. 6.

Bios option:Ratios are only tools it depends upon the uses how to give them practical shape. For example,

profit has different meanings such as EBIT (Earning before Interest and Tax). Some says profit is before interest. Thus personal opinion is different from business to business. 7.

Lack of Comparison:-

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MANAGEMENT ACCOUNTING

19

Different firms adopt different procedures, records, objectives, and policies in such situations, comparison will become more complicated. 8.

Evaluation:There are different tools of ratio analysis, which tool is to be needed in a particular situation

depends upon the skill, training, intelligence and expertise of the analyst. CLASSIFICATION OF RATIOS In order, that ratios serve as a tool for financial analysis, they are classified as: I

PROFITABILITY RATIOS

II

FINANCIAL RATIOS

III TURNOVER RATIOS IV CAPITAL STRUCTURE RATIOS (I)

Profitability Ratios:Profits are always measured in term of sales (or) investment. Profitability ratios measure the

profitability of a firm’s business operations. These ratios are expressed in terms of percentage and always on sales. The following are the important profitability ratios:1.

Overall profitability Ratio:It is also called as “Return on Investment” (ROI) or Return on Capital Employed (ROCE).

It

indicates the relationship between net profit after interest and Tax and the proprietor’s fund. It is most widely used to measure the overall profitability and efficiency of the business. This ratio is useful to share holder’s and management of the company. Higher the ratio reveals how efficiently the company has used share holder’s fund.

Net Profit (after tax and interest) ROI =

x 100 Share holder’s fund

Share holder’s fund = Equity + Preference share capital, Share Premium, Retained Earnings + Surpluses, General Reserves – Accumulated loss if any.

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MANAGEMENT ACCOUNTING 2.

20

Return of Equity Share holder’s Fund:The rate of dividend on equity shares differ year to year, depending upon the amount of profit.

The performance of a Company is judged by the amount of return of equity capital.

Net Profit after tax and preference dividend ROE =

x 100

Equity paid – up This ratio is most suitable to share equity capital share holder’s who want to know how much profit are earned by the company and they(ie. canshare be known howfund) much of dividend will be received by them. holder’s 3.

Return on Total Assets:This ratio is computed to know the productivity of the total assets.

Net Profit after Tax + Interest Return of Assets (ROA) =

x 100 Total assets excluding fictitious assets

Note: Exclude only fictitious assets and not all intangible assets. Fictitious assets includes assets such as preliminary expenses, Debit balance in the profit and Loss account. The inclusion of interest is conceptually sound because total assets have been financed from the ‘pool’ of funds supplied by the creditors and the owners . The objective of computing the ‘Return on Total assets’ is to find out how effectively the funds pooled together have been used. Hence, it will be proper to include the interest in computing the return on total assets. 4.

Earning per share (EPS):This ratio indicates the availability of total profits per share. It is the small variation of return on

equity capital and is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares.

Net profit after tax and preference dividend EPS = Number of equity shares

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The EPS is a good measure of profitability and for comparing EPS of similar companies. EPS calculated for a number of years indicates whether or not earning power of the company has increased. Illustration – 1. Calculate the Earning per share (EPS) from the following date:Net Profit before Tax Rs. 50,000/-, Tax rate 50% 10% preference share capital (Rs.10/- each) Rs.50,000/Equity share capital (Rs.10/- each) Rs. 50,000/Solution:

Net profit after tax and preference dividend Earning per share = Number of equity share

Net Profit after Tax

=

Profit before tax - tax

=

Rs. 50,000 - 25,000 (50%) = Rs. 25,000

Preference dividend

=

10% of Rs. 50,000/-

No. of Equity Shares

=

Rs.50,000 ÷ Rs. 10 = 5000 shares

Earning per share

=

Rs.20,000 ÷ 5000 shares

=

Rs. 4 per share.

= Rs. 5,000

Illustration – 2. From the following information calculate 1

Return on capital employed

2.

Return on share holder’s funds

3.

Return on total assets

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Balance sheet as on ...... Liabilities

Rs.

Assets

Rs.

Share Capital

1,00,000

Fixed assets

8,00,000

Reserves

2,00,000

Current assets

2,00,000

10% Debentures

6,00,000

Creditors

1,00,000 10,00,000

10,00,000

Profit before tax is Rs.1,20,000. Tax rate is 40% Solution: Net profit after tax and interest 1.

Return on capital employed =

x 100 Share holder’s fund or capital employed

Profit before tax

=

Rs.1,20,000

Add interest (10% on debenture of 6,00,000)

=

Rs. 60,000 ----------------Rs. 1,80,000 ------------------

Share holder’s fund

=

Share Capital + Reserves + long term debt

=

1,00,000 + 2,00,000 + 60,000 = 9,00,000 1,80,000

Return on capital employed

= ------------- x 100 = 20% 9,00,000

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x 100 Equity Share Capital


MANAGEMENT ACCOUNTING

23

Net Profit after tax and interest 3. Return on total assets

=

x 100 Total assets excluding fictitious assets

72,000 =

x 100 10,00,000

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24

II.

General Profitability Ratio:-

1.

Operating Ratio:This ratio establishes the relationship between cost of goods sold and other operating

expenses on the one hand and the sales on the other hand. It measures the cost of operations per rupee of sales. This ratio is calculated by dividing operating costs with the net sales and is generally represented as a percentage. Operating ratio is considered to be yard stick of operating efficiency.

Operating cost Operating Ratio

=

x 100 Net Sales

Operating cost

=

Cost of goods sold + Operating expenses

Cost of Goods sold

=

Opening stock

+ Purchases – Closing stock

Manufacturing and Operating expenses =

Administrative

Financial + expenses

Selling +

expenses

expenses This ratio indicates the percentage of net sales that is consumed by operating cost. Higher operating ratio the less favourable it; because it would have a small margin to cover interest, income tax, dividend, reserves. So lower ratio is more favourable. 2.

Operating Profit Ratio:This percentage speaks of how much sales is consumed by operating cost. Higher operating

ratio is always harmful as a small margin is left for interest, income tax, dividend and reserves. It is a test of operating efficiency.

Operating profit Operating Profit Ratio

=

x 100 Net sales

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MANAGEMENT ACCOUNTING 3.

25

Gross Profit Ratio:This ratio expresses the relationship between gross profit and net sales and is usually

represented as a percentage. It is calculated by dividing the gross profit by sales.

Gross profit Gross Profit Ratio

=

x 100 Net Sales

Gross profit

= Sales – Cost of goods sold

It indicates the efficiency of production or trading operations. A high gross profit ratio is a sign of good management as it implies that the cost of production is relatively low. 4.

Net Profit Ratio:This ratio establishes a relationship between net profit (after taxes) and sales and indicates the

efficiency of the management in manufacturing, selling and administrative and other activities of the firm. This ratio is the overall measure of firm’s profitability and is calculated as :

Net Profit after tax Net Profit Ratio

=

x 100 Net sales

It shows what percentage of sales is left to the owners after meeting all costs. An increase in net profit ratio year after year is an indication of improving working conditions and vice versa.

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MANAGEMENT ACCOUNTING 5.

26

Expense Ratios:This ratios indicate the relationship between various expenses and net sales. The operating

ratio reveals the average total variations in expenses. But some of the expenses may be increasing while some be falling. Hence, expenses ratios are calculated by each item of expenses or group of expenses with the net sales to analyse the cause of variations of the operating ratio. The lower ratio is an indication of greater profitability whereas higher the ratio, lower is the profitability.

Particular expense Particular expense ratio =

x 100 Net sales

Specific expenses ratio may be calculated as :

Selling and Distribution Expenses a) Selling and Distribution Expenses Ratio =

x 100 Net Sales

Non Operating Expenses b) Non-operating Expenses Ratio

=

x 100 Net Sales

Cost of goods sold c) Cost of Goods Sold Ratio

=

x 100 Net Sales

Selling and Distributive Expenses d) Administrative & Office Expenses Ratio =

x 100 Net Sales

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Illustration: The following figures relate to Kannan Trades Ltd for the year ended 31st March 2007 st

Trading and Profit and Loss Account for the year ended on 31 March 2007

To To To

Rs. 75,000

Opening stock purchases

3,25,000

Gross Profit

2,00,000

By By By

Sales Less: Returns Closing stock

Rs. 5,20,000 20,000

Rs.

5,00,000 1,00,000

6,00,000 To

Operating expenses: Administration Expenses

To

By

Gross Profit

By

Non operating Income:

2,00,000

40,000

Selling &Distribution To

6,00,000

25,000

65,000

Non operating Expenses:-

Dividend

Loss on sale on assets

Profit on sale of Shares

5,000

Net Profit

9,000

11,000

20,000

1,50,000 2,20,000

2,20,000

Calculate 1) Operating ratio

2) Operating profit Ratio 3) Gross Profit Ratio

4) Net Profit Ratio

Expenses Ratio Solution: 1) Operating Ratio:Operating Cost Operating ratio

=

x 100 Net Sales

Operating Cost Cost of goods sold

=

Cost of goods sold + Operating expenses =

Opening stock + Purchases - Closing stock

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5)


MANAGEMENT ACCOUNTING

Rs.

28

=

75,000 + 3,25,000 - 1,00,000

=

4,00,000 – 1,00,000

=

3,00,000 3,00,000 + 65,000

=

-------------------------- x 100 5,00,000

=

73%

2) Operating Profit Ratio:-

Operating Profit Operating Profit Ratio

=

------------------------

x 100

Net Sales

Operating Profit

=

Gross Profit – Operating Expenses 2,00,000 – 65,000 = 1,35,000 1,35,000

=

------------- x 100 5,00,000

=

27%

3. Gross Profit Ratio:

Gross Profit Gross Profit Ratio

=

------------------ x 100 Net Sales

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------------- x 100


MANAGEMENT ACCOUNTING

4.

29

Net Profit Ratio:-

Net Profit Net Profit Ratio

=

--------------

x 100

Net Sales Expenses Ratio:-

1,50,000 =

----------5,00,000

=

30.%

5. Expenses Ratio: Administrative Expenses a) Administrative Expense Ratio = --------------------------------

x 100

Net Sales

40,000 =

------------ x 100 5,00,000

=

8% Selling and distribution expenses

b) Selling and distribution expenses ratio

=

---------------------------------------- x 100 Net Sales

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MANAGEMENT ACCOUNTING

30

25,000 =

------------- x 100 5,00,000

= II.

5%

FINANCIAL (OR) SOLVENCY RATIOS

Financial Ratios indicate about the financial position of the company. A Company is deemed to be financially sound, if it is in a position to carry on its business smoothly and meet its obligation, both short-term and long-term without strain. It is a sound principle of finance that the short-term requirements of funds should be met out of long-term funds. For example if the payment of raw materials, purchases are made through issue of debentures it will create a permanent interest burden on the enterprise.

Similarly, if fixed assets are purchased out of funds provided by bank overdraft,

the firm will come to grief because such assets cannot be sold away when payment will be demanded by the bank.

Financial ratios can be divided into two broad categories:1. Liquidity Ratios 2. Stability Ratios I

Liquidity (Short-term solvency) Ratios: Liquidity ratios measure the ability of the firm to meet its current obligations. They indicate

whether the firm has sufficient liquid resources to meet its short-term liabilities. The following are important liquidity ratios:1.

Current Ratio:Current ratio is the relationship between current assets and current liabilities. It is calculated by

dividing current assets by current liabilities.

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Current Assets Current Ratio = Current Liabilities The current assets of a firm represent those assets which can be converted into cash within a short period of time, normally not exceeding one year and include cash and bank balances, marketable securities, inventory of raw materials, semi finished and finished goods debtors, provision for bad and doubtful debts, bills receivable and prepaid expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be met within a year, consist of Trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. It is also known as working capital ratio, since it is related to working capital of the firm. A current ratio of 2:1 is considered ideal. That it is, for every one rupee of current liability there must be current assets of Rs.2.

If the ratio is less than two, it may be difficult for a firm to pay current

liabilities. If the ratio is more than two, it is an indicator of idle funds. Limitation:-

It is a crude ratio because it measure only the quantity and not the quality of current

assets. 2. Quick Ratio or Liquidity /Acid Test Ratio:It is the relationship between quick assets and quick liabilities. Quick assets are those assets which readily converted into cash. They include cash and bank balances, bills receivables, debtors, short-term investments. Quick liabilities include creditors, bills payable, outstanding expenses.

Quick Assets Quick Ratio

= Quick liabilities

Quick assets

=

Current assets – (Stock + prepaid expenses)

Quick Liabilities

=

Current Liabilities – Bank overdraft

A Quick ratio of 1:1 is considered satisfactory. Any deviation from this norm indicates either insufficient liquidity of the firm to utilize the resources.

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MANAGEMENT ACCOUNTING II.

32

SOLVENCY RATIOS (LONG-TERM) Solvency ratios assess the long-term financial condition of the firm. Bankers and creditors are

most interested in liquidity.

But share holders, debenture holders, and financial institutions are

concerned with the long-term financial prospects. The following are the widely used solvency ratios:

1. Debt-Equity ratio:The debt-equity ratio establishes the relationship between shore holder’s funds and outsiders funds. Share holder’s funds consist of preference share capital, equity share capital and reserves and surplus Outsider’s fund include all long-term and short-term debts.

Debt Debt – Equity Ratio

=

Outsider’s Fund (OR)

Equity

share holder’s funds

A Debt equity ratio of 1:1 is considered desirable. It gives an idea of the relative proportions of debt and equity in financing the assets of the firm. Debt equity can also be calculated by the following formula:

Long-term debt The Debt above – Equity ratio isRatio useful to =analyse the capital structure of a company. It in

share holder’s funds The above ratio is useful to analyse the capital structure of a company. It indicates the proportion of share holder’s funds and long-term debt in the capital structure. The standard debtequity ratio is 2:1 2.

Proprietory Ratio / Equity Ratio:It is a variant of debt to equity ratio. It establishes relationship between proprietor’s fund and

the total tangible assets. It may be calculated as :

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33

Share holder’s fund Proprietory ratio

= Total tangible assets

Proprietary ratio indicates the proportion of share holder’s funds in the total assets. A high proprietary ratio indicates less danger and risk to creditors in the event of winding up.

III

ACTIVITY (OR) TURNOVER RATIOS:Activity ratios measure the efficiency of asset management. The efficiency in the use of assets

would be reflected by the speed with which they are converted into sales. Activity ratios indicate the relationship between sales and various assets of the firm. In order to find out which part of capital is efficiently employed and which part not, different turnover ratios are calculated. These ratios are as follows: \ 1.

Stock (or inventory) Turnover Ratio:This ratio indicates the number of times stock is turned over during a year.

A high ratio

indicates quick movement of stock and vice-versa.

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34

Cost of goods sold Stock turnover ratio

= Average stock

Cost of goods sold

=

Opening stock + Purchases + Manufacturing cost - Closing stock of inventory

Opening stock + Closing stock Average stock

= 2

2.

Debtor’s Turnover Ratio:- / Accounts Receivable Turnover Ratio:This ratio shows, on an average, the number of times debtors are turned over during a year. A

higher ratio indicates efficiency in assets management and vice-versa.

Net Credit Sales Debtor’s turnover ratio

= Average Debtors

Opening balance + Closing balance Average debtors

= 2

Net credit sales

=

Credit Sales – Sales returns

Debtors

=

Debtors + Bills receivable

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35

Average Collection Period:This ratio indicates the speed with which debtors / accounts receivable are collected. It shows the number of days taken to collect money from debtors.

Debtors + Bills receivable Average Collection Period

No. of

=

x

Working days

Credit Sales

A lower ratio implies quick recovery of money from debtors, when information regarding credit credit sales is not available total sales are taken for calculation of the ratio. 3.

Creditor’s Turnover Ratio:This ratio shows the number of days of credit enjoyed by the unit for purchase of its raw

materials. It is calculated by the folllwing formula.

Credit Purchase Creditors Turnover Ratio

= Creditors

A hgher ratio indicates quick settlement of dues and a lower ratio reflects liberal credit terms granted by suppliers. Average Payment Period:-

It refers to the number of days taken by the form to pay its

creditors.

No. of

Creditors + Bills Payable Average Payment Period

=

x

Working days

Credit Purchase

Generally, lower the ratio, the better is the liquidity position of the firm.

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MANAGEMENT ACCOUNTING 4.

36

Fixed Assets Turnover Ratio:Fixed assets turnover ratio explains the relationship between sales and fixed assets.

Sales Fixed assets turnover Ratio

= Net fixed assets

This ratio indicates the sales generated by every rupee invested in fixed assets. A higher ratio is an indicator of greater efficiency in the utilisation of fixed assets. IV

CAPITAL STRUCTURE RATIO This ratio explain how the caapital structure of a firm is mde up or the debt mix adopted by the

firm. The following ratio fall under this category:Capital Gearing Ratio:- This ratio explains the relationshi;p between equity share holder’s fund on the one hand and preference share capital and fixed interest bearing loan on the other.

Preference share capital + Fixed interest securities Capital Gearing Ratio

= Equity share holder’s funds

If the preference share capital and fixed interest bearing securites exceed equity

If the prfernce share capital and fixed interest bearing securities exceed equity shareholder’s funds, the company is said to be highly geared. The company is said to be low geared, if preference share capital and other fixed- interest bearing securities are less than the equity share holder’s funds. In other words, if the retio is more than one, the capital structure is high geared. If it is less than one, the capital structure is low geared. If the ratiio is equal to one, the capital structure is even geared. Illustration: From the following particulars pertaining to assets and liabilities of a Company, calculate: 1.

Current ratio

2) Liquitidity ratio

3) Proprietory ratio

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4)

37

Debt-equity ratio

5) Capital gearing ratio

Balance sheet as on ........................................

Liabilities

Rs.

Assets

Rs.

5,000 Equity Shares of Rs.100 each

5,00,000

Land and Building

6,00,000

2000 8% Preference shares of Rs. 100 each

2,00,000

Plant and Machinery

5,00,000

4,000 9% Debentures of Rs.100 each

4,00,000

Stock

2,40,000

Reserves

3,00,000

Debtors

2,00,000

Creditors

1,50,000

Cash at Bank

Bank overdraft

50,000

55,000

Prepaid Expenses

16,00,000

5,000 16,00,000

Solution:

Current assets 1. Current Ratio

= Current Liabilities

Current assets

=

Stock + Debtors + Cash + Bank + Prepaid expenses

Rs.

=

2,40,000 + 2,00,000 + 55,000 + 5,000

Rs.

=

5,00,000

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Rs. 1,50,000 + 50,000

=

2,00,000


MANAGEMENT ACCOUNTING

38

Liquid assets 2

Liquid Ratio

= Liquid liabilities

Liquid assets

=

Current Assets – (Stock + Prepaid expenses)

=

5,00,000 – ( 2,40,000 + 5,000)

Rs.

=

2,55,000

Liquid Liabilities

=

Current Liabilities – overdraft

=

2,00,000 – 50,000

=

1,50,000

Rs.

2,55,000 Liquid ratio

=

=

1.7 : 1

1,50,000

Proprietor’s funds 3.

Proprietory Ratio

= Total tangible assets

Proprietors funds

=

Equity Share Capital + Preference share Capital + Reserves and Surpluses

Total asset

Rs.

=

5,00,000 + 2,00,000 + 3,00,000

Rs.

=

10,00,000

Rs.

=

16,00,000

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=

0.625 : 1


MANAGEMENT ACCOUNTING

39

External equities 4. Debt - Equity Ratio

=

Debt =

Internal equities

Debt

Equity

Equity

=

Debentures + Current Liabilities

=

Rs. 4,00,000 + 2,00,000 = 6,00,000

=

Proprietor’s funds = Rs. 10,00,000 6,00,000

om the following, you are required to calculate

Debt - Equity Ratio

a) Debtors turn over b) Average of debtors

=

= 0.6 : 1 10,00,000 2007

2006

Preference share capital + Long-term debt Rs

Rs

bearing fixed interest 5. Capital Gearing Ratio

= Equity share capital + Reserves and Surplus

2,00,000 + 4,00,000 =

=

Illustration 2: From the following, you are required to calculate 5,00,000 + 3,00,000 a) Debtors turn over

=

6,00,000

8,00,000

0.75 : 1

b) Average of debtors

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40

Net sales Debtors (Beginning of the year) Debtors (End of the year)

2007

2006

Rs

Rs

18,00,000

15,00,000

1,72,000

1,60,000

2,34,000

1,72,000

Solution:

Debtors =

Average Debtors =

2006 =

=

= Rs. 1,66,000

2007 =

=

= Rs 2,03,000

Debtors turn over for 2006 =

= 9.04

Debtors turn over for 2007 =

= 8.87

Average of debtors Or Average collection period

=

Ă— No of working days in a year

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41

2006 =

× 365 = 40 days

2007 =

× 365 = 41 days

Illustration 3: A trader purchase goods both on cash as well as on credit terms. The following particulars ae obtained from the books. Rs Total purchases

5,81,000

Cash purchases

30,000

Purchase returns

51,000

Creditors of the end Bills payable at the end Reserve for discount on creditors

1,05,000 60,000

8,000

Calculate average payment period Solution :

Average payment period =

× No of working days in a year

=

× 365 = 120 days

----------

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42

UNIT IV FUNDS FLOW ANALYSIS Every company prepares its balance sheet at the end of its accounting year. It is a statement of assets and liabilities of the company as on a particular date. It reveals the financial position of the company. It does not present a detailed analysis. The balance sheet fails to account for the periodic increase or decrease in the working capital of an enterprise. Hence, another statement has become necessary to show the changes in working capital during a period and explain them. The statement is called fund flow statement. Meaning: The funds flow statement is a report on the movement of funds or working capital. It explains how working capital is raised and used during the accounting period. Definition: “A statement of sources and application of funds is a technical device designed toanalyse the changes in the financial condition of a business enterprise between two dates” – Foulke. It will be appropriate to explain the meaning of the term ‘Funds’ and the term ‘Flow of Funds’ before explain the meaning of the term ‘Funds Flow Statement’. Meaning of Funds: The term ‘Funds’ has a variety of meanings. There are people who take it synonymous to cash and to them there is no difference between a Funds Flow Statement and Cash Flow Statement. While others include marketable securities besides cash in the definition of the term ‘Funds’. The International Accounting Standard No.7 on “Statement of Changes in Financial Position” also recognises the absence of single generally accepted, definition of the term. According to the standard, the term “Fund” generally refers to cash, and cash equivalents, or to working capital of these, the lost definition of the term is by far the most common definition of “Fund”. There are also two concepts of working capital-gross concept and net concept. Gross working capital refers to the firm’s investment in current assets while the term net working capital means excess of current assets over current liabilities. It is in the latter sense in which the term “Funds” is generally used. The terms ‘Current Assets’, ‘Current liability’, non-Current assets and non-current liability are explained below for better clarity. Current Assets: - Current assets are those assets which can be converted in to cash within a short period of time, normally not exceeding one year. These current assets can be of two types:

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Chargeable current assets are those which are appearing as security against bank fiancé, such as inventory, spares and receivables etc. The word inventory includes stocks of raw-materials, and consumable stores, stock in-process and finished goods. Other current assets will include the following:•

Cash and bank balances.

Investment by way of government and trustee securities other than for long term purposes.

Inventory of raw materials, semi-finished and finished goods.

Sundry debtors, provision for bad and doubtful debts

Bills receivable

Prepaid expenses.

Advance payment for tax.

Advance for purchase of raw materials, components and spare parts etc.

Current Liabilities: The current liabilities defined as liabilities which are short-term maturing obligations to be met within a year. These include: •

Trade creditors for raw materials and consumable stores and spares

Bills payable

Bank credit

Provision for taxation, sales tax, excise etc.

Dividends payable

Outstanding expenses

Unsecured loans

Public deposits maturing within one year

Interest and other charges accured but not due for payment

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Non – Current Assets: All assets other than current assets come within the category of non-current assets. Such assets include good will, land and building, machinery, furniture, long-term investment, patent rights, trade marks, debit balance of profit and loss account, discount on issue of shares and debentures, preliminary expenses. Non-Current Liabilities: All liabilities other than current liabilities come within the category of non current liabilities. They include share capital, long-term loans, debentures, share premium, credit balance in the profit and loss account, revenue and capital reserves (e.g. general reserve, dividend equalisation fund, debentures sinking fund, capital redemption reserve) etc. Concept of Flow of Funds: The term ‘flow means change and therefore the term ‘flow of funds’ means ‘change in funds’ or ‘change in working capital’. In other words, ‘flow of funds’ means any increase or decrease in working capital. If the transaction results in the increase of funds, it is called a source of funds, if it results in the decrease of funds, it is known as an application of funds. If the transaction does not affect the working capital there is no flow of funds. The flow of fund occurs only when a transaction involves are current account and another non-current account. When a transaction involves non-current accounts only, no flow of fund occurs since working capital is not altered.

Example, issue of shares in consideration for machinery.

Similarly if a transaction affects current accounts only, no flow of fund occurs. Example collection of cash from debtors or payment of cash to creditors. Thus, to facilitate a flow of fund (change in working capital) the transaction must affect one current account and another non-current account. Example, issue of shares in consideration for stock acquired, cash payment for building etc. Objectives: The main objectives of fund flow statement are: 1. To show how resources have been obtained and used 2. To indicate the results of current financial management 3. To throw light up on the most important changes that have taken place during a specified period 4. To show how the general expansion of the business has been financed 5. To indicate the relationship between profits from operations, distribution of dividend and raising of new capital or term loans

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6. To have an assessment of the working capital position of the concern

MANAGERIAL USES OF FUNDS FLOW ANALYSIS The funds flow statement is of primary importance to the financial management. It is an essential tool for financial analysis. The uses of funds flow statement are:

1.

Analysis of financial operation:

The main purpose of funds flow statement is to analyse the financial operations of the business. The statement explains the causes for changes in the assets and liabilities during a period. It also indicates the effect of these changes on the liquidity of the firm.

2.

Evaluation of the firm’s financing:

The analysis of sources of funds reveals how the firm has financed its development projects in the past. It also reveals the rate of growth of the firm.

3.

Allocation of scarce Resources:

A projected funds flow statement is an instrument for allocation of resources. It lays down the plan for efficient use of scarce resources in future. It enables the management to discharge its financial obligations promptly.

4.

Helps in working capital management: Funds flow statement indicates the adequacy or inadequacy of working capital.

The

management can take steps for effective use of surplus working capital. In case of inadequacy, arrangement can be made for improving the working capital position. 5.

Acts as a Guide to future: With the aid of projected funds flow statement, the management can plan for meeting future

financial requirements. 6.

Helps financial Institutions:

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The funds flow statement is also useful to lending institutions like banks IDBI, ICICI, IFCI and others.

It helps them to assess the credit worthiness and repaying capacity of the borrowing

company. 7.

Answers to intricate questions: The funds flow statement provides answers to questions such as: 1. Why were the net current assets of the firm down, though the net income was up or vice versa? 2. How was it possible to distribute dividends in absence of or in excess of current income to the period? 3. How was expansion in plans and equipment financed? 4. How was the sale proceeds of plant and machinery used? 5. How the loans were repaid? 6. What become to the proceeds of share issue or debentures issue? 7. How was the increase the working capital financed? 8. Where did the profits go?

LIMITATIONS OF FUNDS FLOW STATEMENT: The limitations of funds flow statement are listed below: 1. Funds flow statement is not a substitute for an income statement or balance sheet.

It

provides only some additional information regarding changes in working capital. 2. Changes in cash are more important and relevant for financial management than the working capital. 3. It is not an original statement. It is only a rearrangement of date given in financial statement. 4. Funds flow statement is essentially historic in nature. A projected funds flow statement, on the basis of it can not the prepared with much accuracy. 5. It can not reveal continuous changes.

PREPARATION OF FUNDS FLOW STATEMENT: In order to prepare a funds flow statement, It is necessary to fixed out the “Sources” and “Applications” of funds.

The term ‘Funds’ refers to working capital.

Transactions that increase

working capital are sources of funds. Transactions that decrease working capital are applications of funds. The following are the main sources and applications of founds.

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Sources of Funds

Applications of Funds

1.

Funds from operations

2.

Issue of shares and debentures

3.

Raising of long term loans

3.

Repayment of loans

4.

Income from investment

4.

Purchase of long term investments

5.

Sale of fixed assets and long term

5.

Purchase of fixed assets

6.

Payment of taxes and dividend

7.

Drawings (In the case of sole trading concern

investments

1.

Funds lost in operations

2.

Redemption of preference shares and debentures

or partnership firm) 8.

1.

Loss of cash by embezzlement

Funds from operation:

Profit of a period is an important source of funds. The profit and loss account reveals the net profit or loss of business. The net profit is arrived at after taking into account all terms of income and expenditure (both operating and non-operating, both funds items and non-funds items). To arrive at funds from operating, adjustments are made in net profit for non-found and non-operating items. It will be clear from the following:

Calculation of funds from operations:

Net profit earned during the year Add:

xxxx

Non-fund and non-operating items Which are already debited to P & L a/c: Depreciation on fixed assets

xxxx

Good will written off

xxxx

Discount on issue of shares, written off

xxxx

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Less:

48

Preliminary expenses written off

xxxx

Patents written off

xxxx

Transfer to reserves

xxxx

Loss on sale of fixed assets

xxxx

Non – fund or Non – operating items Which are already credited to P & L a/c: Profit on sale of fixed assets

xxxx

Profit on revaluation of assets

xxxx

Rent received

xxxx

Discount received

xxxx

Refund of income tax

xxxx

Funds from operation xxxx

It the profit and loss account shows a net loss, the above procedure will be reversed. 2.

Issue of shares and debentures: Either in term of issuing debentures, or preference shares or equity shares constitutes major

source of working capital. For example, a company issues Rs2,00,000 equity shares at a premium of 10% Rs 2,20,000 constitutes a source of working capital as it increases cash (CA) and increases NCL. It is important to remember that the face value of the security is immaterial; it is net amount received from the transaction that constitutes the source. 3.

Sale of non-current assets: It is not unusual for a business firm to sell one or more of its non-current assets particularly in

the case of plants and equipment either because they have become useless or more efficient plant and machinery equipment have appeared in the market. If the sale is made for cash or a receivable current assets increase. So, the sale proceeds from the disposition of non-current assets is the source of funds. Whether the non-current asset is sold at a profit or at a loss, is irrelevant for the

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purpose. The amount is received or receivable in the near future constitute the source. For example, a plant and machinery having a net book value of Rs30,000 has been sold for Rs 20,000; Rs 20,000 would constitute the source of funds; the cost (loss) of Rs10,000 would be transferred to profit and loss account. If it is sold for Rs40,000; Rs40,000 would constitute the source of funds and Rs10,000, being profit, transferred to profit and loss account. 4.

Funds from increase in share capital: Issue of shares for cash or for any other current assets results in increase in working capital

and hence there will be a flow of funds

Application of funds: The uses to which funds are put one called ‘applications of funds’. Following are some of the purposes for which funds may be used: 1. Redemption of preference shares and debentures: The retirement of long term liabilities such as payment to preference shareholders and debenture holders involves the use of cash. There is corresponding decrease in long- term liabilities. It should be borne in mind that it is not the face value of the security redeemed that is important; the important thing is to know the actual payment made to retire such securities. 2. Purchase of fixed assets: Purchase of fixed assets such as land, building, plant, machinery, long-term investment etc results in decrease of current assets without any decrease in current liabilities. Hence, there will be a flow of funds. But incase shares on debentures are issued for acquisition of fixed assets, there will be no flow of funds. 3. Payment of tax liability: Provision for taxation is generally taken as an appropriation of profits and

not as an

application of funds. But if the tax has been paid, it will be taken as an application of funds. 4. Recurring payment to investors: Dividends and interest constitute the recurring payments to investors. It represent another use of funds.

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PROCEDURE FOR THE PREPARATION OF FUNDS FLOW STATEMENT: Fund flow statement is usually prepared for one year on the basis of balance sheets and additional information. Preparation of funds flow statement involves the following steps:1. Schedule of changes in working capital: Working capital is the difference between current assets and current liabilities. The schedule of changes in working capital is prepared to fixed out the increase or decrease in working capital during the year. Current assets and current liabilities are taken to the schedule. Working capital at the end of the current year is compared with that of the previous year. The difference is either increase or decrease in working capital. Increase in current assets will lead to increase in working capital and vice-versa on the other hand, increase in current liabilities will lead to decrease in working capital and vice-versa. Increase in working capital will appear on the application side of fund flow statement. Decrease in working capital win appear on the ‘sources’ side of fund flow statement. Proforma of statement of changes in working capital

Effects on working capital

Previous Year

Current Year

Increase

Decrease

Rs

Rs

Rs

Rs

Current Assets: Stock Debtors Cash Bank B/R

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Prepaid expenses Total (a) Rs

Current liabilities: Creditors B/P Outstanding expenses Total (b) Rs

Working capital: (Difference between Decrease in working capital) Total Rs

2. Opening of Accounts of Non – Current items: Accounts are prepared for non – current items to ascertain the source or application of funds. In the preparation of accounts for non – current items, additional information is to be considered. For st

st

example, the value of machinery on 31 March 2006 and 31 March 2007 are Rs 20,000 and Rs 25,000 respectively and depreciation charged during the year is Rs 5,000. The account will appear as below: Machinery A/c Rs To Balance b/d

20,000

To Cash A/c (B/F)

10,000

By Adjusted P/L A/c

Rs

(Depreciation)

5,000

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By Balance c/d

30,000

25,000

30,000

The balancing figure represents purchase of machinery. It is an application of funds. 3. Preparation of Adjusted profit and loss Account: The adjusted profit and loss account is prepared to ascertain funds from operation or funds lost in operation. The regular profit and loss account shows only the net profit or loss. To ascertain the funds generated by operations the adjusted profit and loss account is prepared by taking into account only the non – fund and non – operating items. Non – fund items refer to expenses and income which do not involve any changes in working capital. Example, depreciation transfer to general reserve, writing back of provision for tax etc. Non – operating items refers to expense and income which not directly related to business operations of the company. Example, dividend received refund of tax, profit/loss on sale of assets etc. the balancing figure in the adjusted profit and loss account is either funds from operations or funds lost in operations.

4. Preparation of funds flow statement The above three steps are incorporated in the preparation of funds flow statement. Statement of sources and Applications of Funds Sources

Applications Rs

Rs

1. Issue of share capital

xxxx

1. Redemption of preferences shares

xxxx

2. Issue of debentures

xxxx

2. Redemption of debentures

xxxx

3. Raising of long term loans

xxxx

3. Repayment of loans

xxxx

4. Income from investments

xxxx

4. Purchase of long term investments

xxxx

5. Sale of fixed assets and long

xxxx

5. Purchase of fixed assets

term investment

xxxx

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6. Funds from operations

xxxx

6. Payment of taxes and dividends

xxxx

7. Non-trading income

xxxx

7. Drawings (in case of sole trading

xxxx

concern or partnership firm)

Total

8. Funds lost in operation

xxxx

9. Non-trading expenses

xxxx

xxxx

Total

Decrease in working capital as

xxxx

Increase in working capital as per statement

per statement of changes in

of changes in working capital

working capital

xxxx

xxxx Total

xxxx

Total

xxxx

Illustration: From the following balance sheets of Mr Rajesh prepare a funds flow statement. th

Liabilities

th

30 June 2006

30 June 2007

Rs

Rs

th

Assets

Creditors

18,000

20,500

Cash

Bank loan

15,000

19,500

Capital

77,000

78,000

Total

1,10,000

1,18,000

th

30 June 2006

30 June 2007

Rs

Rs 5,000

2,300

Debtors

17,500

19,200

Stock

12,500

11,000

Land

10,000

15,000

Building

25,000

27,500

Machinery

40,000

43,000

1,10,000

1,18,000

Drawings of Mr Rajesh during the year was Rs20,000. Depreciation charges on machinery was RS 4,000.

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Solution: Schedule of changes ijn working capital th

th

30 June

30 June

2006

2007

Rs

Increase

Decrease

Rs

Rs

Rs

5,000

2.300

---

2,700

Debtors

17,500

19,200

1,700

---

Stock

12,500

11,000

---

1,500

Total (A)

35,000

32,500

Creditors

18,000

20,500

---

2,500

Total (B)

18,000

20,500

Working capital (A-B)

17,000

12,000 5,000

5,000

---

17,000

6,700

6,700

Particulars

Current Assets: Cash

Less: Current Liabilities

Decrease In working capital

--17,000

th

Sources and applications of funds during the year ended 30 2007 Sources

Rs

Applications

Rs

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Bank loan

4,500

Funds from operation

25,000

Decrease in working capital

5,000

Purchase of land

5,000

Purchase of building

2,500

Purchase of machinery

7,000

Drawings

34,500

20,000 34,500

Working: Machinery account Rs To Balance b/d To cash (purchase)

40,000 7,000

Rs By adjusted P/L A/c (depreciation) By Balance C/d

47,000

4,000 43,000 47,000

Capital Account Rs

Rs

To Drawings

20,000

By Balance b/d

77,000

To Balance C/d

78,000

By adjusted P/L A/c ( Net profit)

21,000

98,000

98,000

Adjusted Profit and Loss account Rs To Machinery

4,000

To Net profit

21,000 25,000

Rs By funds form operators

25,000

25,000

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Distinction between funds flow statement and income statement: The main difference between funds flow statement and income statement are given below; 1. Funds flow statement is prepared to know the sources and uses of working capital. But an income statement is prepared to know the results of the business activities ie profit or loss. 2. Funds flow statement matches the funds raised with funds applied.

No distinction is made

between capital and revenue items. But the income statement matches cost of goods sold with sales to ascertain profit or loss. It deals with revenue items only. CASH FLOW STATEMENT Cash flow analysis is another important technique of financial analysis. It involves preparation of cash flow statement for identifying sources and application of cash. Cash flow statement may be prepared on the basis of actual or estimated date. Cash flow statements summarize sources of cash inflows and uses of cash outflows of the firm during a particular period of time. It can be prepared for a year, half year, quarter or for any other duration.

Objectives: The objectives of cash flow analysis are: 1. To show the causes of changes in cash balance between two balance sheet dates. 2. To indicate the factors contributing to the reduction of cash balance in spite of increase in profits and vice-versa.

Significance and uses of cash flow statement: Cash flow statement is vital significance to the financial management. Its chief advantages are: 1. The cash flow statement explains the reasons for low cash balance in-spite of huge profits or large cash balance in spite of low profits. 2. It helps in short – term financial decisions relating to liquidity.

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3. It shows the major sources and uses of cash. The management with the aid of projected cash flow statement can know a. How much cash will be needed b. From which sources it can be obtained c.

How much can be generated internally

d. How much could be obtained from outside

4. It helps the management in planning the replacement of loans, replacement of assets, credit arrangement etc. It is also significant for capital budgeting decisions. 5. On the basis of past year’s cash flow statements projections can be made for the future. The projected cash flow statement helps in planning for the investment of surplus or meeting the deficit. 6. A comparison of actual cash flow statement with the projected cashflow statement helps in understanding the variations and control of cash expenditure. Preparation of cash flow statement: Cash flow statements is usually prepared for one year on the basis of balance sheet and additional information. Preparation of cash flow statements involves the following steps: 1. Opening of accounts for Non-Current items: Accounts are prepared for non-current items to ascertain the inflow and outflow of cash. In the preparation of accounts for non-current items, additional information is to be considered. For example, the value of plant (as per balance sheet) on 31

st

March 2005 and 31

st

March 2006 is

Rs40,000 and Rs 50,000 respectively and depreciation charged during the year is Rs 10,000. The account will appear as below: Plant Account Rs

Rs

To Balance b/d

40,000

By Adjusted P/L A/c (Depreciation)

10,000

To cash ( Balancing figure)

20,000

By Balance c/d

50,000

60,000

60,000

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The balancing figure represents purchase of plant. It is an out flow

of cash.

Thus by

opening of accounts or by comparing non-current items, inflow and out flow of cash are found out. 2. Preparation of adjusted profit and loss Account:The adjusted profit and loss account is prepared to ascertain cash trading profit or cash trading loss. The regular profit and loss account shows only the net profit or loss. It does not show the cash profit realised by trading. Suppose, the net profit shown by profit and loss account is Rs 10,000. It depreciation of Rs 5,000 had been changed and preliminary expenses written off were Rs5,000, the cash trading profit would be Rs20,000 (10,000+5,000+5,000). In the preparation of adjusted profit and loss account, the non-cash and non – operating items are alone taken into account. Non- cash items refer to expenses or income which do not cause any change in cash. Example, depreciation, preliminary expenses written off etc. Non-operating items refer to expenses and income which are not directly related to operations of the company. Examples, dividend or interest received, refund of tax, profit or loss on sale of assets etc. The balancing figure in the adjusted profit and loss account is either cash trading profit or cash trading loss. 3. Comparison of current items to determine inflow or outflow of cash: Individual current assets like stock, debtors, prepaid expenses are compared. Increase in current assets is taken as an out flow of cash and vice-versa. For example, if stock shows an increase of Rs5,000 over the balance of the previous year, out flow of cash is Rs 5,000. Increase in current liabilities is taken as in flow of cash and vice-versa. 4. Preparation of cash flow statement:The above three steps are incorporated in the preparation from of cash flow statement. A cash flow statement can be prepared in the following form:

Cash flow statement for the year ending on……………….. Balance as on………….. Cash Balance

xxxx

Bank Balance

xxxx

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Add: Sources of cash: Issue of shares

xxxx

Raising of long term loans

xxxx

Sale of fixed assets

xxxx

Short term borrowings

xxxx

Cash from operations : Profit as per P/L account

xxxx

Add/Less Adjustment for non-cash items:Add : Increase in current liabilities

xxxx

Decrease in current assets

xxxx

Less : Increase in current assets

xxxx

Decrease in current liabilities

xxxx

Total Cash available (1)

Xxxx xxxx

Less : Applications of cash:Redemption of redeemable Preference shares

xxxx

Redemption of long-term loans

xxxx

Purchase of fixed assets

xxxx

Decrease in deferred payment liabilities

xxxx

Cash out flow on account of operations

xxxx

Tax paid

xxxx

Dividend paid

xxxx

Decrease in unsecured loans, deposits etc

xxxx

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xxxx Total cash available (2) •

xxxx

Closing Balance: Cash Balance

xxxx

Bank Balance

xxxx xxxx

This total should tally with the balance as shown by (1) – (2)

Difference between cash flow statement and funds flow statement: Following are the points of difference between a cash flow statement and funds flow statement: 1. In a cash flow statement, only cash receipts and payments are recorded. But in a funds flow statement increase or decrease in working capital is recorded. 2. The cash flow statement indicates the causes for changes in cash position. The other hand, a funds flow statement shows the causes of changes in working capital. 3. Cash flow statement is appropriate for short range planning. While funds flow statement is appropriate for long range planning. 4. Whenever there is inflow of cash there will definitely be inflow of funds. But it is not viceversa. Inflow of funds does not necessarily mean inflow of cash. 5. Cash flow statement starts with opening cash balance and closes with the closing cash balance. But there is no opening and closing balances in funds flow statement. Illustration:- Statement of financial position of Mr.Kumar is given below:

Liabilities: Accounts payable Capital

30.06.2006

30.06.2007

Rs

Rs

29,000

25,000

7,39,000

6,15,000

Assets

30.06.2006

30.06.2007

Rs

Rs

Cash

40,000

30,000

Debtors

20,000

17,000

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Stock Building Other fixed assets Total

7,68,000

6,40,000

8,000

13,000

1,00,000

80,000

6,00,000

5,00,000

7,68,000

6,40,000

Additional information:a. There were no drawings b. There were no purchases or sale of either building or other fixed assets. Prepare a statement of cash flow. Solution:Cash flow statement of Mr Kumar Sources Opening cash balance Decrease in debtors

Rs

Uses

40,000 3,000

Rs

Decrease in accounts payable

4,000

Increase in stock

5,000

Cash trading loss

4,000

Closing cash balance 43,000

30,000 43,000

Working: Building account Rs To Balance b/d

1,00,000

Rs By adjusted P/L A/c (depreciation)

20,000

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By Balance C/d 1,00,000

80,000 1,00,000

Other fixed assets account Rs To Balance b/d

Rs

6,00,000

By adjusted P/LA/c (depreciation)

1,00,000

By Balance C/d

5,00,000

6,00,000

6,00,000

Capital Account Rs

Rs

To Net loss

1,24,000

To Balance c/d

6,15,000

By Balance b/d

7,39,000

7,39,000

7,39,000

Adjusted P/L Account Rs

Rs By Balance b/d

To Building A/c (Depreciation) To other fixed assets a/c (Depreciation) To Cash trading loss

20,000

By Net loss (Transfer to Capital A/c)

--1,24,0000

1,00,000 4,000 1,24,000

1,24,000

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63

After taking into account the under mentioned items, Jain Ltd made a net profit of st

Rs.1,00,000 for the year ended 31 Dec 2006. Rs Loss on sale of machinery

10,000

Depreciation on building

4,000

Depreciation on machinery

5,000

Preliminary expenses written off

5,000

Provision for Taxation

10,000

Good will written off

5,000

Gain on sale of buildings

8,000

Find out Cash from operations Solution: Calculation of cash from operations Rs Net profit earned during one year Add:

1,00,000

Non – cash and non- operating expenses: Loss on sale of machinery

10,000

Depreciation on building

4,000

Depreciation on machinery

5,000

Preliminary expenses written off

5,000

Provision for Tax Good will written off

10,000 5,000 1,39,000

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Less:

64

Non – Cash and non – operating income: Gain on sale of buildings Cash trading profit

Add:

8,000 1,31,000

Decrease in current assets and increase in --Current liability

Less:

Increase in current assets and decrease in

---

Current liability Cash from operations

1,31,000

________________

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UNIT – V MARGINAL COSTING Materials, labour and other expenses constitute the different elements of cost.

These

elements of cost can broadly be put into two categories: Fixed costs and variable costs. Fixed cost are those costs which do not vary but remaining constant within a given period of time and range of activity in spite of fluctuations in production. Variable costs are those costs which may increase or decrease in proportion to increase or decrease in output. The cost of product or process can be ascertained using different elements of costs according to any of the following two techniques: 1. Absorption costing and 2. Marginal costing Absorption costing technique is also termed as Traditional or Full cost method. According to this method, the cost of a product is determined after considering both fixed and variable cost. The variable costs, such as those of direct materials direct labour etc, are directly changed to the products while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus in case of absorption costing all costs are identified with the manufactured products. Under marginal costing technique, only variable costs are taken into account for purposes of product costing, inventory valuation and other important management decisions and no attempt is made to find suitable bases of apportionment of fixed costs. Marginal costing is also known as Direct costing or variable costing. It is the most useful technique which guides the management in pricing, decision making and assessment of profitability. Concept of Marginal costing: Marginal costing is a technique where only the variable costs are considered while computing the cost of a product. The fixed cost are met against the total fund arising out of the excess of selling price over total variable cost. This fund is known as contribution in marginal costing. According to the institute of cost and work Accountants, London, “Marginal Costing is the ascertainment by differentiating between fixed costs and variable costs, of marginal cost and of the effect on profit or changes in the volume and type of output”. According to the chartered Institute of management Accountants, London, “Marginal costing is a technique where only the variable costs are charged to cost unit, the fixed cost attributable being written off in full against the contribution for that period”. This will be clear with the help of the following illustration.

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Illustration: A company is manufacturing three products A,B and C. The costs of their manufacture are as follows:Products A

B

C

Rs

Rs

Rs

Direct materials per unit

3

4

5

Direct labour per unit

2

3

4

Selling price per unit

10

15

20

1,000

1,000

1,000

Particulars

Out put (units)

The total over heads are Rs 6,000 output of which Rs3,000 are fixed and rest are variable. Prepare a statement of cost and profit according to the marginal costing technique.

Solution:-

Product A Particulars

Product B

Product C

Per unit

Total

Per unit

Total

Per unit

Total

Rs

Rs

Rs

Rs

Rs

Rs

Direct materials

3

3,000

4

4,000

5

5,000

Direct labour

2

2,000

3

3,000

4

4,000

Variable over heads

1

1,000

1

1,000

1

1,000

Total Marginal cost

6

6,000

8

8,000

10

10,000

Contribution

4

4,000

7

7,000

10

10,000

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(sales – variable cost) Selling price

10

10,000

15

15,000

20

20,000

Thus the total contribution from the three products A,B and C amounts to Rs 21,000 (4000+7000+10,000). The profit will be computed as follows: Rs Total contribution

21,000

Fixed costs

3,000 18.000

Hence it is clear that marginal costing is not a system of cost finding such as job, process or operating costing, but it is a special technique concerned, particularly with the effect of fixed overheads on running the business. The concept of marginal costing is a formal recognition of ideas understanding flexible budgets, break - even analysis and cost volume profit relationship. It is an application of these relationship which involves a change in the conventional treatment of fixed overheads in relation to income determination. Features of Marginal Costing:1. All costs are classified into two-fixed and variable 2. Only the variable costs (Marginal Costs) are treated as the cost of the product. 3. The stock of finished goods and work in progress are valued at marginal cost only. 4. Fixed costs are charged against the contribution earned during the period. 5. Prices are based on marginal cost plus contribution. Contribution is the difference between selling price and variable cost. Marginal Costing Vs Absorption Costing: Since marginal costing is an alternative to absorption costing, it is necessary to compare the two and suggest if possible, the technique is more appropriate in routine costing. Following are the important points of distinction between absorption costing and marginal costing:-

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1. Absorption costing is a total cost technique. That is, both variable and fixed costs are charged to projects. In marginal costing only variable costs are charged to products. 2. Absorption costing values stock at cost which includes fixed cost also. On the other hand, marginal costing values stock at variable costs only. This results in higher value of stock under absorption costing than under marginal costing. 3. In absorption costing, managerial decisions are guided by net profit which is the excess of sales over total cost. In marginal costing, decisions are guided by ‘Contribution’ which is excess of sales over overhead costs. 4. In total cost technique, there is the problem of apportionment of fixed costs since fixed costs are also treated as product costs.

Marginal costing excludes fixed costs.

Therefore there is no question of arbitrary apportionment. The above points of difference between absorption costing and marginal costing will be clear with are help of the following illustration: A Company has a production capacity of 2,00,000 units per year. Normal capacity utilisation is reckoned as 90% standard variable production costs are Rs11 per unit. The fixed costs are Rs3 ,60,000 per year. Variable selling costs are Rs 3 per unit and fixed selling costs are Rs 2,70,000 per year. The selling price per unit is Rs20. In the year end on 30

th

June 2003, the production was th

1,60,000 units and sales were 1,50,000 units. The closing inventory on 30 June 2003 was 20,000 units. The actual valuable production costs for the year were Rs 35,000 higher than the standard

Calculate the profit for the year: a) by the absorption costing method and b) by the marginal costing method Also explain the difference in the profit.

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Solution: In absorption Costing method th

Profit statement for the year ended 30 June 2003 Amount (Rs.)

Sales:

1,50,000 units at Rs.20 per unit

Less:

Cost of Production:

Amount (Rs)

30,00,000

Variable production cost for 1,60,000 units at Rs.11 per unit 17,60,000 Increase in fixed cost

35,000

Fixed Cost

3,60,000 21,55,000

Add: Opening stock = 10,000 units (i.e. Sales 1,50,000 units + Closing stock 20,000 units – production 1,60,000 units) at Rs. 13 (i.e. variable normal capacity unitlisation) 1,30,000 22,85,000 Less:

Closing stock: 20,000 values 21,55,000 current cost

x 20,000 1,60,000 2,69,375

Less:

20,15,625

Gross Profit

9,84, 375

Gross Profit

9,84,375

Selling expenses:

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Variable

4,50,000

Fixed

2,70,000 Net Profit

7,20,000 2,64,375

In Marginal costing method th

Profit statement for the year ended 30 June, 2003 Amount (Rs) Amount (Rs.)

1,50,000 units at Rs.20 per unit Sales:

30,00,000

Margin Cost: Less:

Variable production cost for 1,60,000 units at Rs.11 per unit Additional variable production cost variable cost of opening stock of finished costs

17,60,000 35,000 1,10,000

19,05,000 Closing stock of finished goods: 20,000 units valued at current variable production cost Less:

17,95,000 x 20,000

2,24,375

1,60,000 Variable production cost of 1,50,000 Units 16,80,625

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Variable selling cost of 1,50,000 units (1,50,000 x 3)

Add:

71

4,50,000 21,30,625

8,69,375 Contribution Fixed cost: Less:

Fixed production cost

3,60,000

Fixed selling cost

2,70,000

Net Profit

6,30,000

2,39,375

The difference in profits Rs. 25,000 (i.e.Rs. 2,64,375 – 2,39,375) as arrived at under absorption and marginal costing methods is due to the element of fixed cost included in the valuation of opening and closing stock under the absorption costing method. Which technique is preferable? Since absorption costing and marginal costing are alternative techniques in the routine cost accounting, it is necessary to say about their appropriateness for product costing. Absorption costing may be preferred on the following grounds. 1. In modern times foxed costs constitute a substantial portion of total cost production is impossible without incurring fixed costs. As such they are a apart of cost of production. 2. Inclusion of fixed costs in inventory valuation become absolutely necessary if building up of stocks is a necessary part of business operations. For example, in the case of timbers and fire works stocks have to be build-up. If fixed costs are excluded from inventory valuation fictions losses have to be shown in earlier years and excessive profits when goods are actually sold. 3. Profit fluctuations are less when production is constant but sales fluctuate. 4. This technique enables matching of costs and revenue, in the period in which revenue arises and not when costs are incurred. 5. The inclusion of fixed costs does not give room for fixation of price below total cost although some contribution is generated.

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Marginal costs may be preferred as on the following grounds:1. This technique is simple to understand and easy to operate. 2. Individual fixed costs need not be apportioned on an arbitrary basis. 3. It avoids the contingency of over / under absorption of overheads. 4. Fixed costs accrue on time basis. Hence they should be written off in the period of accrual 5. Accounts prepared under this technique more nearly approach the actual cash flow position. In the light of above arguments in favour of each of techniques, it is not possible to lay down any general rule regarding the use of a particular technique. It is the cost accountant who is the right person to decide in favour of either of the two having regard to its appropriateness to a particular organization. While absorption costing is the basis of financial accounting, it is equally so in the routine cost ascertainment procedure; Since the use of full marginal costing system for product costing is very rare in modern times. However for purposes of planning and decision making marginal costing is the only technique which is universally recognized. Marginal costing – Role of contribution:Contribution is of vital importance for the system of marginal Costing Contribution is the difference between sales and variable costs and it contributes towards fixed costs and profit. It helps in sales and pricing policies and measuring the profitability of different proposals. Contribution is a sure test to decide whether a product is worthwhile to be continued among different products. Contribution

=

Sales – Variable cost

Contribution

=

Fixed cost + profit

Fixed Costs and Variable costs: In marginal costing, a point from ‘Contribution’ the concepts of ‘fixed costs’ and variable costs’ are also important. Expenses that do not vary with the volume of productions are known as fixed expenses. Eg. are Manager’s salary, rent and taxes, insurance etc.

It should be noted that

fixed charges are fixed only within a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a price, fixing policy. Fixed Cost per unit is not fixed. Expenses that vary almost in direct proportion to the volume of production or sales are called variable expenses. Eg. Electric power and fuel, packing materials, consumable stores. It should be noted that variable cost per unit is fixed. However to say that fixed costs that do not vary is wrong. Accordingly, even fixed costs become variable beyond a particular point.

If production increases, substantially additional

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accommodation and additional executive staff cause an increase in rent, insurance, salaries etc. There are also other factors such as inflation, Government’s policies, and management decisions which bring about a change in the level of fixed costs. Since, fixed costs do not, in total, respond to changes in the level of activity, an increase in volume will result in a decrease in the fixed cost per unit. According to the ICMA Terminology, semi variable costs is “A Cost containing both fixed and variable elements which are partly affected by fluctuations in the volume of output or turnover. In other words, semi variable expenses possess both fixed and variable characteristics. Salaries of foremen and supervisors, electricity charges, telephone charges etc. fall under this category. Semi variable cost is also known as semi fixed costs since it contains both fixed and variable elements i.e. semivariable costs are costs which are mainly variable with a significant fixed element or mainly fixed with a significant variable element. Illustration: Prepare marginal cost statement from the following particulars:Variable cost :

Rs.

Direct material

4,500

Direct Wages

2,500

Factory over heads

1,500 --------

Fixed costs

8,500

Administrative expenses

1,250 --------

Total cost Profit

9,750 5,250 ---------

Sales

15,000 ---------

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Solution: Marginal Cost Statement

Rs. Sales

Less:

Rs. 15,000

Variable cost : Direct materials

4,500

Direct wages

2,500

Factory over heads

1,500 Contribution

Less

8,500 6,500

Fixed cost: Administrative expenses

1,250 Profit

5,250

Illustration: Determine the amount of fixed expenses from the following particulars:-

Sales

2,50,000

Direct Material

80,000

Direct Labour

50,000

Variable overhead

20,000

Profit

60,000

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Solution: Calculation of mixed expenses:Marginal Cost Statement Rs. Rs.

Sales Less:

2,50,000

Variable cost : Direct material

80,000

Direct Labour

50,000

Variable overhead

20,000 Contribution

Less:

Fixed Expenses B/F.

1.50,000 1,00,000 40,000

Profit

60,000

Merits of Marginal Costing:1. Marginal costing helps in taking decisions such as pricing, accepting foreign orders at low price, to make or buy, selection of suitable product mix etc. 2. It yields better results when combined with standard costing. 3. It enables effective cost control by dividing costs into fixed and variable costs. 4. It enables the proper apportionment of fixed costs. 5. It avoids the complication of over-recovery or under recovery of overheads. 6. It facilitates the study of relative, profitabilily of different products when a number of products are being manufacturing. 7. Inventory valuation becomes more realistic when it is based on marginal cost. 8. Since fixed costs are not absorbed in unsalable stock, there is no question of fictitious or false profits.

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Demerits:1. It is difficult to separate fixed and variable costs clearly 2. There are semi-variable costs. They are not considered in the analysis. 3. It ignores time element. In the long run, all costs including fixed costs change. Therefore, comparison of performance between two periods on the basis of contribution is not possible. 4. Since valuable overheads are apportioned on estimated basis, problem of under or over recovery cannot be totally eliminated. 5. Price fixation and comparison between two jobs can be done without considering fixed costs. 6. The stock is valued at marginal cost. Hence, in the case of loss due to fire, full loss cannot be recovered from the insurance company. 7. Valuation of inventories and profit estimations based on marginal costing are objected to by tax authorities. 8. In controlling costs, marginal costing is not useful in concerns where fixed costs are huge in relation to variable costs. 9. It is found unsuitable in industries like ship building, contract etc., where the value of work-inprogress is high in relation to turnover. If fixed expenses are ignored in the valuation of workin-progress, losses may occur every year till the contract is completed. On completion there may be huge profit. It may create income tax problems. 10. The systems of budgetary control and standing costing serve the purpose better than marginal costing. Hence, this technique is no required. BREAK EVEN ANALYSIS There may be change in the level of production due to many reasons, such as competition, introduction of new product trade depression or boom, increased demand for the product, scarce resources, change in the selling prices of products, etc. In such cases management must study the effect on profit on account of the changing level of production. The management uses Break Even Analysis, which is the technique to do such study. The term Break Even Analysis is interpreted in the narrower as well as broader sense in narrower sense it is concerned with finding out the break even point i.e. level of activity where the

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total cost equals total selling price used in the broader sense It means that the system of analysis which determines the probable profit at any level of production. The break even analysis establishes the relationship of costs, volume and profits.

So this analysis is known as Cost Volume Profit

Analysis. It is an important technique used in profit planning and managerial decision – making. Break-even Chart:Break even analysis is made through graphical charts. Break-even chart indicates approximate profit or loss at different levels of sales volume within a limited range. The break-even charts show fixed and variable costs and sales revenue so that profit of loss at any given level of production or sales can be ascertained. Steps involved in construction of a Break-even Chart :Step - 1:

Select a scale for sales (units) on horizontal axis.

Step – 2:

Select a scale for costs and revenues on vertical axis

Step – 3:

Draw the fixed cost-line parallel to the horizontal axis.

Step – 4:

Draw the total cost line, starting from the point on the vertical axis which represents fixed costs.

Step – 5:

Draw the sales line, starting from the point of origin (Zero) and finishing at point of maximum sales.

Step – 6:

The sales line will cut the total cost line at the point where the total cost equal to total revenues.

Step – 7:

The point of intersection of two lines is called ‘break-even point’. i.e. the point of no profit no loss.

Step – 8:

The lines drawn from intersection to horizontal axis and vertical axis give the sales value and number of units produced at break-even point.

Step – 9:

The loss is shown if the production is less than the break-even point and profit is shown if the production is more than the break-even point.

Step – 10:

The total sales minus break-even sales represent the margin of safety.

Step – 11:

The angle which the sales line makes with total cost line, while intersecting it at break-even point is called ‘angle of incidence’

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Costs

Angle of incidence

Sales (Rs.)

B.E. Point

B.E Sales (Rs.)

Margin of safety

Fixed cost B.E. Sales (Units) Production (units)

Production Units

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Importance of break-even point:1.

Break-even point helps assessing the viability of the organization and to take decisions in

profit planning and cost control. Break-even point is the point of zero net income where the level of sales is just equal to its costs. 2.

Costs include both fixed and variable costs. It is used as a useful tool in financial planning

to recover cost and to maximize profits. 3.

The changes in operating condition such as, selling price, variable cost and fixed cost will

change the break-even point. 4.

For calculation of break-even point, the costs need to be segregated into fixed cost and

variable costs. 5.

Break even point indicates the level of operating capacity and sales to be achieved to

recover all costs. Any further activity or sales beyond break-even point will lead to earn profit for the concern. Formulae for Break-even Analysis:

Fixed Cost Break-even Point (units) = Contribution per unit Fixed Cost Break-even Point (Rs.) = P/V Ratio (or) Break-even units x Selling price per unit Contribution P/V Ratio

=

x 100 Sales

Fixed Cost + Desired profit Desired Sales =

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P/V Ratio At Break-even point Contribution

= Fixed Cost

Contribution

– Fixed Cost = 0 ASSUMPTIONS OF BREAK-EVEN ANALYSIS

The following assumptions are important considerations in break-even analysis. 1.

The break-even analysis requires that all costs should be classified into fixed and variable

components. 2.

It is assumed that all fixed costs remain constant at various levels of activity.

But in

practice, it may not be fixed in the long run. 3.

Another assumption is that variable costs are really variable and changes in direct

proportion to the volume of out put In practice variable costs are not necessarily strictly variable with output. 4.

It is assumed that production units and sales units are equal and no inventory exists in the

beginning or at the end of the period for which analysis is made. In practice, there will always be existence of inventory. 5.

There will be no change in selling price and it remains constant at all levels of output and

further assumed that there is no change in the sales mix. 6.

It is assumed that productivity, operating efficiency, product specifications and methods of

manufacture and sales will not undergo any change 7.

A break-even chart can depict the position of only one product and fails to present various

products in the sales mix in one chart and different charts are required to be drawn for different products. 8.

Break-even analysis ignores the capital employed in business, which is one of the

important facts in determination of profitability of the company and its products.

ADVANTAGES OF BRAKE-EVEN CHART

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Visualises the information very clearly:- The chart visualizes the information very clearly

and a glance at the chart gives a vivid picture of the whole affair. The different elements of cost-direct materials, direct labour, overheads (factory, office and selling etc.) can be presented through an analytical break-even chart. 2.

Profitability of different products can be known:-

The profitability of different products can

be known with the help of break-even charts, besides the level of no profit no loss. The problem of managerial decision regarding temporary or permanent shutdown of business or contribution at a loss can be solved by break-even analysis. 3.

Demonstration of effect of changes in fixed and variable cost:- The effect of changes in

fixed and variables costs at different levels of production or profits can be demonstrated by the graph legibly. The relationship of cost, volume and profit at different levels of activity and varying selling prices is shown through the chart. Thus, it indices the requisites for survival of the company. 4.

Exercising Cost Control :- The break-even chart shows the relative importance of he fixed

cost in the total cost of a product. If the costs are high, it induces management to take measures to control such costs. Thus, it is a managerial tool for control and reduction of costs, elimination of wastage and achieving better efficiency. 5.

Effect of economy and efficiency:- The Capacity can be utilized to the fullest possible

extent and the economies of scale and capacity utilization can be effected.

Comparative plant

efficiencies can be studied through the break-even chart. The operational efficiency of a plant is indicated by the angle of incidence formed at the intersection of the total cost line and the sales line. 6.

Helps in forecasting and long term planning:-

Break-even analysis is very helpful for

forecasting, long – term planning, growth and stability. LIMITATION OF BREAK-EVEN CHARTS There are certain limitations of break-even charts – They are:1.

Stock changes affect income:The break-even chart depicts the volume of production or sales along the X-axis and thus

ignores the effect of changes in stock volume. As a matter of fact, it is assumed that stock changes will not affect the income. This is not true, since the absorption of fixed costs depends on production and not on sales. 2.

Condition of growth not assured:-

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Condition of growth or expansion in an organization are assumed under break-even analysis. In actual life of any business organization, the operations undergo a continuous process of growth and expansion. 3.

Fixed costs do not always remain constant:The assumption underlying break-even chart do not normally hold good in every business

concern.

Fixed costs vary and do not remain constant at all levels of production. They have a

tendency to raise to some extent after the production is increased beyond a certain level. 4.Variable Costs do not always Vary Proportionately:The variable costs also do not always change in the same proportion in which the volume of production or sales changes. Usually the production cost iincreases if the law of diminishing return is applicable. This presents difficulty in the drawing of the total cost line end the fixed cost line. 5.Sales revenue does not always changes proportionately:

Sales revenue do not vary proportionately with changes in volume of sales due to reduction in selling price as a result of competition or increased production.

Illustration:- Balaji Ltd provides the following data of its operations:-

Selling price per unit Rs:10 variable cost per unit Rs6, fixed cost per annum Rs 80,000 construct break –even chart and ascertain the break-even point.

Variable Output

Sales

Fixed cost

Total cost

Profit/loss

Contribution

Rs

Rs

Rs

Rs

Cost units

Rs Rs

0

-

-

80,000

80,000

80,000

5,000

50,000

30,000

80,000

1,10,000

60,000

20,000

10,000

1,00,000

60,000

80,000

1,40,000

40,000

40,000

15,000

1,50,000

90,000

80,000

1,70,000

20,000

60,000

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20,000

2,00,000

1,20,000

80,000

2,00,000

0

80,000

25,000

2,50,000

1,50,000

80,000

2,30,000

20,000

1,00,000

30,000

3,00,000

1,80,000

80,000

2,60,000

40,000

1,20,000

From the above data we can observe that at 20,000 units of production the total revenue is equal to total costs and we can say 20,000 units is break-even level of production from the above data we can prepare break-even chat as shown belows:

B.E. Point

Margin of safety

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Fixed cost line

5,000

10,000

15,000

20,000

25,000

30,000

Break – even level of output Profit-volume Ratio Profit-volume Ratio (p/v) reveals the rate of contribution per product as a percentage of turnover It indicates the relationship of the contribution to sales. It helps in knowing the profitability of the business. This ratio calculated with the following formula:

× 100

P/v Ratio =

illustration: Sekar Ltd

has provided the following information sales(@ Rs5 per unit) -20,000 units,

variable cost per unit Rs3, fixed cost Rs8,000 per annum-calculate the P.V Ratio and the break-even sales of the company. Solution:

P/v Ratio

=

=

×100

×100

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= 40% (or) 0.40

Break – even sales =

=

= Rs 2,00,000/-

Margin of safety: The margin of safety refers to sales in excess of the break-even volume. It represents the difference between sales at a given activity level and sales at break-even point.

It is important that there should be a reasonable margin of safety to run the operations of the company in profitable position. A low margin of safety usually indicates high fixed over heads so that profits are not made until there is a high level of activity to absorb the fixed costs. Margin of safety provides strength and stability to a concern.

MARGIN OF SAFETY IS CALCULATED BY USING THE FOLLOWING FORMULAE

Margin of safety = Actual sales – Break-even sales

or

or

=

=

Margin of safety as % Total sales =

x 100

Illustration: st

You are given the data of Bharathi Ltd, for the year ended 31 March 2007, Sales (@Rs10)1,00,000 units variable cost per units. Rs6, fixed cost per annum Rs.3,00,000 Calculate the margin of safety.

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Solution:

Break – even sales =

=

Margin of safety

= 75,000 units

= Actual sales –Break – even sales = 1,00,000 units – 75,000 units = 25,000 units = 25,000 units x Rs 10 = Rs 2,50,000/-

Illtstration: You are reqired to calculate a) P.V Ratio b) Margin of safety c) Sales d) Variable cost from the following figures. Fixed cost Rs12,000; profit Rs1,000, Break even sales Rs 69,000

Solution:

a) Break – even sales =

Rs 60,000 =

By cross multiplication Rs 60,000 x P.V Ratio = Rs 12,000

~ P.V Ratio =

x 100 =20%

b) Margin of safety: =

=

x 100 = Rs 5000/-

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c) Sales = B.E Sales +margin of safety = Rs 60,000 + Rs5,000 = Rs 65,000/= d) variable cost: Sales = Rs 65,000 Contribution = Fixed cost + profit = Rs 12,000+Rs 1000 = Rs 13000 Variable cost = sale-contribution = Rs 65,000 - Rs13,000=Rs 52,000/-

CAPITAL BUDGETING

Capital budgeting ting is the process of making investment decisions regarding capital expenditures. A capital expenditure is an expenditure incurred for acquiring or improving the fixed, assets the benefits of which are expected to be received over a number of years in future. Capital expenditure involves non- flexible long-term commitment of funds. Capital budgeting is also known as long-term planning for investment decisions. Charless T.Horngreen has defined capital budgeting as, “a long term planning for making and financial proposed Capital outlays�.

Need and importance of capital Budgeting:Capital Budgeting decisions are among the most crucial and critical business decisions special

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care should be taken in making these decisions on account of the following reasons:1. Heavy investment: All capital expenditure projects involve heavy investments of funds. These funds are raised by the firm from various external and internal sources. Hence it is important for a firm to plan its capital expenditure.

2. Permanent commitment of funds:- The funds involved in capital expenditures are not only large but also more or less permanently blocked. Therefore, these are long term investment decisions. The longer, the time the greater is the risk involved. Hence careful planning is essential

3. Long term effect on profitability:- Capital budgeting decisions have a long term and significant effect on the profitability of the concern. If properly planned, they can increase the size scale and volume of sales as well as growth potential of the concern.

4. Irreversible in nature: In most case, capital budgeting decisions are irreversible. Once the decisions for acquiring a permanent assets is taken, it is very difficult to reverse that decision. This is because, it is difficult to dispose of these assets without incurring heavy losses. LIMITATION OF CAPITAL BUDGETING 1. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in same particular circumstances. 2. The technique of capital budgeting require estimation of future cash inflow and out flows. The future is always uncertain and the data collected for future may not be exact. Obviously the results based upon wrong data cannot be good. 3. There are captain factors like morale of the employees, goodwill of the firm etc which cannot be correctly quantified but these otherwise substantially influence the capital decision.

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I - TRADITIONAL TECHNIQUES 1.PAY-BACK PERIOD METHOED:Pay-back method is popularly known as pay-off, or pat out method. It is defined as the number of years required to recover the initial outlay invested in a project. Computation of pay Back period:It can be calculated as follows:

Pay back period =

The method can be under stand as follows: If the annual cash in flow are uniform, the pay-back period can be computed by dividing cash outlay (initial investment)by annual cash inflows. If cash inflow of each year is not uniform, the calculation of payback period takes a cumulative form. In such a case, the pay -back period can be found out by adding up the figure of net cash inflows until the total is equal to initial investment. The annual cash inflow is calculated by taking into account net income before depreciation but after taxation.

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If there are two projects the project which has a shorter pay-back period will be chosen. First, Net inflow shall be calculated as follows:Cash in flow from sales revenue

-

Less: Operating expenses including depreciation

-

Net income (before Tax) Less : Income Tax Net income (after Tax)

-

Add: depreciation

-

Net cash inflows

-

Note: As because depreciation does not affect the cash inflow. It shall not be taken into consideration in calculating net cash inflow but it is admissible deduction under Income tax Act, it has been deducted from the gross sales revenue and added in the net income (after tax). Mertis: 1 It is easy to calculate and simple to understand 2.It is preferred by executives who like quick answers for selection of the proposal. 3.It is useful where the business is suffering from shortage of funds as quick recovery is essential for repayment. 4. It is useful for industries subject to uncertainty, instability or rapaid technological changes 5.It is useful where profitability is not important,

Demerits: 1.This method is delicate and rigid. A slight change in the operation cost will affect the cash inflows and the pay-back period

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2.It does not take into account the life of the project, depreciation, scrap value, interest factor etc. 3.It completely ignores cash inflows after the pay-back period. 4. The profitability of the project is completely ignored 5.It gives more importance to liquidity as a goal of capital expenditure decisions which is not justifiable 6. It ignores time value of money, cash flows received in different year are treated equally.

Suitability: Inspire of the above demerits, the pay-back method can profitably be used in each of the following cases: 1. This method is suitable where political or other conditions are seemed to be hazy. 2. It is suitable when a firm suffers from liquidity crisis 3. It is also suitable for a firm which focus on short –term earning performance of the firm rather its long – term growth. 4. It is a suitable method where production is subject to change in technology.

Illustration: A company is considering two mutually exclusive projects. Prefects. Both require an initial as outlay of Rs10,000 each and have a life of 5 years. The companies required rate of return is10% and pays tax at 50% rate. The projects will be depreciated on a straight line basis. The net cash flow (before tax expected to be generated by the projects as follows:

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92 Cash inflows

year

Project I

Project II

I.

Rs 4,000

Rs 6,000

II.

4,000

3,000

III.

4,000

2,000

IV.

4,000

5,000

V.

4,000

5,000

Calculate payback of each project Solution: Calculation of Net Income and cash flow after taxes: Project I - cash inflow is uniform:-

year

Cash flow before Taxes

Depreciation

Income

taxes

Before Tax

Rs

Rs

Rs

Rs

Net

Net Cash flow

income

after Taxs

Rs

Rs

1

4,000

2,000

2,000

1,000

1,000

3,000

2

4,000

2,000

2,000

1,000

1,000

3,000

3

4,000

2,000

2,000

1,000

1,000

3,000

4

4,000

2,000

2,000

1,000

1,000

3,000

5

4,000

2,000

2,000

1,000

1,000

3,000

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Pay back period =

=

=3

years

Project – II cash inflow is not uniform:Income year

Cash flow before taxes

Deprecation

Before

Taxes

Net income

Net cash flow

Rs

Rs

After taxes

Taxes Rs

Rs

Rs

Rs

1

6,000

2,000

4,000

2,000

2,000

4,000

2

3,000

2,000

1,000

500

500

2,500

3

2,000

2,000

0

0

0

2,000

4

5,000

2,000

3,000

1,500

1,500

3,500

5

5,000

2,000

3,000

1,500

1,500

3,500

The above table shows that in three years Rs8,500/- (4000+2500+2000)has been recovered. th

Rs1500 is left out of initial investment. In the 4 year the cash inflow is Rs.3500/-. It means payback rd

th

period is between 3 and 4 years ascertained as follows:

Payback period = 3 years +

=3

years

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2. AVERAGE ACCOUNTING RATE OF RETURN METHOD It is also known as Accounting rate of return because it takes into account the Accounting concept of profit (i.e profit after deprecation and tax) and not the cash in flows. The project which yields the highest rate of return is selected.

The accounting rate of return may be calculated by any of the following methods:

ARR =

x 100 or

ARR =

x 100

The term average annual profit refers to average profit after depreciation and tax over the life of the project;The average investments can be calculated by any of the following methods

=

or

=

Merits1.It is simple to understand and easy to calculate 2. This method gives due weightage to the profitability of the project 3. It takes into consideration the total earnings from the project during its life time 4. Rate of return may be readily calculated with the help of the accounting data.

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Demerits: 1. It uses accounting profits and not the cash inflows in appraising the project 2. It ignores the time value of money profits earned in different prides are valued equally. 3. It considers only the rate of return and not the life of project 4. It ignores the fact that profit can be reinvested 5. This method does not determine the fair rate of return on investment

Illustration:

A project requires an investment of Rs5,00,000 and has a scrap of Rs20,000 after 5 years. It is expected to yield profits depreciation and taxes during the five years accounting to Rs 40,000, Rs 60,000, Rs 70,000, Rs 50,000 Rs 20,000. Calculate the average rate of return on the investment.

Solution: Total profit = Rs 40,000 + Rs 60,000 +Rs 70,000 + Rs 50,000 +Rs 20,000 = 2,40,000

Average profit =

= Rs 48,000

ARR =

=

x 100

x 100 = 20%

II- DISCOUNTED CASH FLOW METHOD

This method is also known as “Time adjusted rate of return” (or) Internal rate of return method. It

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takes in to account both the profitability and the time value of money. This method is based on the fact that future value of money will not be equal to the present value of money. For example, assume of Rs 100 received after one year because by receiving the amount now and investing it some where a fame can get Rs110 (say including 10% interest) after one year. Discounted cash flow methods for evaluating capital investment proposals are or are of three types : 1.Net present value method 2. Excess present value method 3. Internal Rate of return

1. Net present value method:Under this method present value and compare with the original investemend if the present of cash inflows is calculated at the required rate of return (an arbitrary rate of return) and compare with original investment. If the present value is higher than the original investment, the project can be selected otherwise rejected. Formulae to know the present volume of Rs.1 to be received after a specified period at given rate of discount

PV = P 1 -

P =Principal r =Rate of discount

2.EXECSS PRESENT VALUE INDEX:

This is a refinement of the net present value method. Instead of working out the net present value, a present value index is found out by comparing the total present value of cash inflows and the total

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present value of cash out flows. This can be calculated as follows:

Excess prevent value index =

x100

The higher the profitability index the more desirable is the investment.

3.

INTERNAL

RATE

OF

RETURN:

Internal rate of return is the rate of return at which total present value of future cash inflows is equal to initial investment. This method is used when the amount of investment and cash inflows are known but the rate of return is not known. The rate of return is generally found by trial and error method. For example, if a sum of Rs800/- invested in a project becomes Rs1000/- at the end of the year the rate of return comes to25%calculated as follows:

I

Where, I=cash out flow ie initial investment R=cash inflow r=Rate of return yield by the investment (or) IRR

Thus,

(or) 800+800 r =1000 800 r = 1000-800=200 R=

=0.25 (or) 25%

Merits of discounted cash flow method:

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1.

This method considers the entire economic life of the project.

2.

It gives due weightage to time factor. That is time value of money is considered

3.

It

facilitates

comparison

between projects 4.

This

approach

by

recognishing time factor, makes sufficient provision for uncertainty and risk. 5.

It is the best method where cash in flows are uneven

Demerits:1.

It involves a great deal of calculations. Hence it is very difficult forecast and complicated.

2.

It is very difficult to forecast the economic life of any investment exactly.

3.

The

selection

of

an

appropriate rate of interest is also difficult.

4.Profitability Index It is also known as benefit / cost ratio. It is the ratio of present value of the future net cash flows to the initial cash outlay of the project. The index provides a relative measure for judging desirability and evaluating the worth of an investment proposal. It can be calculated as follows:

Debtors =

It is used as accept or reject criteria for the project. It PI >I then accept the project and PI < I, reject the project. Illustration: The gamma Co., Ltd., is considering the purchase of a new machine. Two alternative machines A and B have been suggested each costing Rs4,00,000. Earnings after taxation are expected are as follows Year

Machine A

Machine B

Rs

Rs

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1

40,000

1,20,000

2

1,20,000

1,60,000

3

1,60,000

2,00,000

4

2,40,000

1,20,000

5

1,60,000

80,000

The company has a target of return on capital of 10% and on this basis, you are required to compare the profitability of the machines and share which alternative you consider finally preferable. Note: The present value of Rs1, 10% due in : 1. Year = 0.91 2. Year = 0.83 3. Year = 0.75 4. Year = 0.68 5. Year = 0.62

Solution: Machine A Year

Machine B

Discount factor @ 10%

Cash inflow Rs

Present value

Cash inflow

Present value

Rs

Rs

Rs

1.

.91

49,000

36,400

1,20,000

1,09,000

2.

.83

1,20,000

99,000

1,60,000

1,32,000

3.

.75

1,60,000

1,20,000

2,00,000

1,50,000

4.

.68

2,40,000

1,63,000

1,20,000

81,600

5.

.62

1,60,000

99,200

80,000

49,600

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Present value of cash inflows =

5,18,400

5,23,200

Machine A Net present value = =

Machine B

5,18,400 -4,00,000

5,23,200 -

1,18,000

4,000

= 1,23,200

Profitability Index =

=

=

=1.29

The net present values as well as the profitability index are higher in case of machine ‘B’ and hence machine ‘B’ will be preferred.

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